Can a Minskyian Perspective explain the Financial Crisis 2008?

Can a Minskyian Perspective explain the Financial Crisis 2008?
Author Tomas Freitas

Introduction
Since 1957, Minsky has argued that a high capitalist economy with developed financial institutions is basically unbalanced, and will plunge into a depression as a consequence of a period of debt-financed “euphoria”. Minsky’s strictures were abandoned throughout the long boom of the 1960s, and even during the oil and Third World debt shocks of the 1970s (Keen, 1995). However, his theories cannot be disregarded after a long period of economic instability which began with the collapse of securitization of home mortgages in 1987 (Minsky, 2008). The collapse of the sub-prime market in August 2008 has been widely tagged a “Minsky moment,” (Palley, 2009). This current crisis has invited many economists to interpret what is really going on and why these kinds of crisis are repeated. Apart from Marxist theories of economic crisis, there are a number of political economists attempting to follow and draw a picture of the roots of the crisis - one of them is Hyman Minsky.

This essay will attempt to explain how the current financial crisis relates to a traditional Minsky hypothesis. Minsky’s theory of financial instability hypothesis comes from John Maynard Keynes general theory (2008), which is argued by Adam Smith in his views of market processes in his book “An Inquiry into the Nature and Causes of The Wealth of Nations: Book IV, Chapter 2,” (1776).
These contradictory arguments have inspired Minsky to elaborate his financial instability hypothesis. To generate his hypothesis, Minsky uses several approaches including debt deflation by Irving Fisher, the credit view of money by Joseph Schumpeter which is in favour of Institutional Structural, Minsky’s own Cushions of Safety which were reviewed by Jan Kregel, as well as Minsky’s non-financial firms such as hedge fund, speculative and ponzi units. The financial instability hypothesis also is incorporated with the view of profits, which is developed by Kalecki (1991) and Levy (1983).

However, this essay will be limited to discussing two different views of Keynes and Smith which are fundamental to Minsky’s financial instability hypothesis and which have re-generated into two basics theories of “debt-deflations” and “cushions of safety” with the help of two importance variables including “Ponzi Pyramids” and “Institutional Structures”. Before moving into those discussions, the essay will provide a short biography of Minsky.

A biography of Minsky
Hyman Philip Minsky was born on 23 September 1919, completed his bachelor degree in Mathematics at Chicago University in 1941, and achieved his MPA in 1947 and PhD in 1954 at Harvard University. Two Chicago professors were the most significant early influences on his thought (Minsky, 1985). The inspiration to study economics came from Oskar Lange, who was at that time working out a synthesis of Marx and neoclassical economics that he called market socialism (Lange, 1938). Henry Simons was the source of Minsky’s lifelong interest in finance, as well as the idea that the fundamental flaw of modern capitalism came from its banking and financial structure (Simons, 1948). Taken together, Lange’s model of a possible socialism and Simons model of the ‘good financial society,’ represented the central features of Minsky’s ideal economic system,’ from which he would later analyse and criticise existing economic structures (Mehrling, 1999). After a sabbatical in 1969-70, Minsky seemed to view himself as Keynesian, seen through his assessment of certain fundamental institutional issues. Afterwards he became opposed to not only to monetarism but also to mainstream Keynesianism (Minsky, 1972). 

Financial Instability Hypothesis
Minsky’s Financial Instability Hypothesis mainly draws from Keynesian ‘General Theory’, which has identified “the capital development of the economy” as an economic problem rather than, “the allocation of giving resources among alternative employments”. As a detailed illustration, Minsky emphasises that the exchange of present money for future money is representative of the capital development of capitalist economy in the present day (Minsky, 1992).

Minsky has identified that the capital development of a capitalist economy provides a range of possibilities to build up financial fragility, which is why, in Minsky’s opinion, it is necessary to provide regulations and interventions. This notion is a synthesis of two fundamental arguments by Adam Smith and John Keynes about the result of market processes. We can see these two fundamental views about the outcome of a market economy have been achieved. One of them, as stated by Adam Smith, is as follows:

“As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention” (Smith, 1776, IV, Ch 2).

Keynes has interpreted Smith’s legacy of invisible hands in these days as speculatory behaviour, which is practically implemented by debtors and lenders in guarantee loans. In opposition to Smithian speculation, Keynes states his legacy of the alternative to the invisible hand – comparative static approach to economics.  Keynes wrote:
 “If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the terms of enterprises for assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organization of investment markets improves, the risk of the predominance of speculation does however, increase. Speculators do no harm as bubbles on a sea of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill done” (Keynes, 2008, 142).

According to Minsky, in designing and advocating policies and practices, economists are likely to have to choose between Smithian and Keynesian theories, Smithian theory being that the market “always” leads to the promotion of the public welfare, and the Keynesian theory that market processes “may” lead to poor capital development of the economy (Minsky, 1991). The only answer to the “invisible hand” conjecture is to apply appropriate regulations and interventions, if the results of poor capital development are serious (1992b). The financial instability hypothesis was used to explain the great financial construction of the United States in the 1932-1933, where the United States faced a crisis in the savings and loans of the banking system (Minsky, 1992b). According to Minsky, the phenomena of changes in the institutions combined with the ordinary approach and bad performances of private and public decision makers has become vital to weaknesses, which often suggests promises of an overall theoretical perspective to current troubles always leading up to these problems (Minsky, 1977, 140).

The system of capitalist economy evolved in the mid 1960s; this was a period of financial innovation, well known as the era of financial markets. The first serious test of financial innovation came in 1966 in the municipal bond market and the second in 1970 with a run of commercial paper – but each of these was determined through prompt central bank action (Minsky, 2008). Financial innovations are related to what has come to be known as Minsky’s financial instability hypothesis, which has allowed an existing quantity of high-powered money to support greater expenditure. Innovations allow “a pyramiding of liquid assets” to replace cash, government bonds, or short term bank debt in portfolios. This increases the instability of the system since failure by only a few large firms (financial or non-financial) to meet debt commitments can lead to an increase in failures as assets are written-down (Fazzari & Papadimitriou, 1992). According to Thomas Palley (2009), Minsky’s financial instability hypothesis supports the reasoning that capital financial systems have an inherent proclivity to financial fragility, and that this proclivity can be summarised in the maxim “Success breeds success breeds failure” or “Success breeds excess breeds’ failure”.

Minsky’s framework is one of evolutionary instability and it can be thought of as resting on two different cyclical processes. The first cycle can be labelled the “basic Minsky cycle” while the second can be labelled the “super-Minsky cycle.”
The basic Minsky cycle concerns the evolution of patterns of financing arrangements, and it captures the phenomenon of emerging financial fragility in business and household balance sheets. The cycle begins with “hedge finance” when borrowers’ expected revenues are sufficient to repay interest and the loan principal. It then passes on to “speculative finance” when revenues only cover interest. Finally, the cycle ends with “ponzi finance” when revenues are insufficient to cover interest payments and borrowers are relying on capital gains to meet their obligations.

The basic Minsky cycle offers a psychologically-based theory of the business cycle. Agents become progressively more optimistic, which manifests in increasingly optimistic valuations of assets and associated revenue streams and willingness to take on increasing risk in belief that the good times are here forever. This optimistic psychology afflicts both borrowers and lenders and not just one side of the market. That is critical because it means market discipline is progressively removed.

This process of rising optimism is evident in the way business cycle expansions tend to generate talk about the “death of the business cycle.” In the 1990s there was talk of the “new economy” that was supposed to have killed the business cycle by inaugurating a period of permanently accelerated productivity growth. In the 2000’s there was talk of the “Great Moderation” that claimed central banks had tamed the business cycle through improved monetary policy based on improved theoretical understanding of the economy. This talk is not incidental but instead constitutes evidence of the basic Minsky cycle at work. Moreover, it afflicts all, including regulators and policymakers. For instance, Federal Reserve Chairman Ben Bernanke himself indicated in 2004 that he was a believer in the Great Moderation hypothesis.  
 
Debt Deflation or Over-Indebtedness
In the Keynesian view, over-protection during good times can be a result of crisis in the savings and loans and the banking system, a consequence of sectoral indebtedness by running out of the ability of sectoral cash flows to validate the contracts (Minsky, 1991).
Keynes ‘general theory’ also contained some elements of the financial instability hypothesis, provided by political economists such as Irving Fisher with his classical description of debt deflation. In Fisher’s argument, over-indebtedness is the only factor that disturbs general economic equilibrium. He also assumed that at some point in time a state of over-indebtedness will exist, which will tend to lead to liquidation, through the alarm either of debtors or creditors or both (Fisher, 1933).

Minsky’s analyses on Fisher debt-deflation has several emphasis, one being that debt-deflation occurs only while investment and capital assets are financed as economies have the benefit of an extended period of good times. Minsky also identified improvements in the market; like alterations in institutions, which is compatible with new instruments such as communicating and computing, is one aspect of the way financing changes over extended periods of good times. However, in Fisher’s theory of debt-deflation, he did not explain how over-indebtedness developed (Minsky, 1994).

Minsky also states that finance allows for a much faster growth of income and capital accumulation but, at the same time, increases the stock of debt, and the associated financial commitments affects the level of expected cash flows (Gatti & Gallegati, 1990). Over-indebtedness also tends to constrain investment by business and debt-financed consumption households. The United States economy was at that time burdened by a deadweight government debt accumulated as a result of the dreadful abuse of the government budget during the 1980’s, an abuse which is continuing today. These conditions mean that a recovery from the current recession will not be accompanied by buoyant private demand (Minsky, 1992b).

Hedge, Speculative and Ponzi Finance
Which factors determine the importance of borrowers and lenders risk in establishing the level of investment? To address that question, Minsky distinguishes non-financial firms according to whether they are what he terms hedge, speculative, or ponzi units (Pollin, 1997).

As mentioned above, hedge financing has a normal cash flow large enough to meet both principle and interest that is due on debts. Speculative financing has the income of the debtor large enough to meet the interest but not principle payments and Ponzi financing takes place when not enough is earned to meet even the interest due on debts. Speculative finance involves rolling over debts and Ponzi finance involves the capitalisation of interest (Minsky, 1991).

Essentially, a Ponzi collapse is a debt crisis: when there is too much debt accumulated by an economic agent, and there is no way to either get the resources to pay the debt including interest, postpone the payments, or shift the debt on to someone else, economic agents such as debtors and lenders will face bankruptcy (Nesvetailova, 2008). According to Jan Kregel of the Levy Institute, the types of debt are critically related to the way risk has been valued, assessed, and modelled by banks and financial institutions since the liberalisation reforms were introduced in the 1980s (Kregel, 2008).

So, now comes the question, can debt-deflation theory with the help of Ponzi pyramids units explain the recent financial crisis? Yes, indeed, because oversupply of housing was exacerbated when interest rates were increased and hundreds of thousands of lower middle income borrowers in the United States could no longer afford their mortgage payments, (Gupta, 2008). Moreover, the diversification of collateral debt obligations into rating CCC which targeted the sub-prime level market meant that mortgages could not be re-sold because prices had dropped (Jarvis, 2009).

Cushions of Safety
Numerous analysts have distinguished the relevance of Hyman Minsky’s financial instability hypothesis to understanding the current crisis in the financial systems of developed countries. Central to Minsky’s analysis of financial fragility was the concept of a cushion of safety, an initiative related to the prominent security analyst and hedge fund investor Benjamin Graham cited in (Calandro, 2009).
The “cushion” covers the margin of error in anticipated returns from an investment project. Minsky analysed the investment decision from the point of view of the difference between prospective cash receipts and cash commitments that represent the margin of safety. For instance, the margin of safety for a banker lending to a businessman for a particular project would be determined by the difference between the amount loaned and the amount required to finance the project. The margin could also be determined by realisation of the value of the collateral required of the borrower, the amount of compensating deposits, or any other factor that the banker believed would allow him to recover his loan if future income from the project disappointed expectations (Kregel, 2008).
According to Jan Kregel (2008), financial fragility increased by a deliberate and unnoticeable erosion of margins of safety in the relative normal circumstances. He states that this situation can be drawn to holding-up payments, suffering borrowing, or even distress transactions of inventory and productive assets. In these activities sometimes, the banker may propose re-possession of the collateral behind the loan.

The result is a debt deflation process in which “position has to be sold to make position” and the downward pressure on prices raises real debt burdens. Lower prices increase the necessity to sell and reinforce the excess supply, making it even more difficult for the investor to fully repay his/her loan from asset sales (Kregel, 2008).

Minsky describe the weaknesses of banking institutions, which are usually better informed about the overall market environment and potential competitors, and are inherently sceptical of the borrower’s estimate of future cash flows and thus insist on margins of safety. The problem of declining margins of safety is because in the earlier 1980s there was an introduction of neoliberal concepts, well known as the “Washington consensus”. This original concept was written by Friedman and Hayek (Legge, 2009), and promoted by the Reagan and Thatcher governments. One of the central ideas is financial deregulation. Before the arrival of the neoliberal approach to economic thinking and policy, very strict regulations were applied by Section 20 of the Glass-Steagall Act of 1933 (Rosenblum, 2003). This regulation was to restrict the commercial banks from affiliating with firms “engaged principally” in potential profitability activities, such as underwriting and dealing in securities.  Since the Washington consensus, the commercial banks have urged relaxation of these and other constraints on their ability to enter new markets and new lines of business (Tarullo, 2008). As a result, for the first time in 1987 the Federal Reserve authorised an exemption on such a subsidiary and the first securitised investment vehicle was created the following year. Financial deregulation and liberalisation, so highly praised a decade ago, turned out to be a dangerous beast, and has gotten out of hand of the public authorities. According to the data from the Deutsche Borse Group, the current Over the Counter (OTC), about 84% of all trade in financial derivatives take place in the markets, not in regulated exchanges (Tarullo, 2008, 6).

Recent Financial Crisis
Let’s see if Minsky can explain the recent crisis which happened in the sub-prime mortgage market in the United States. Subprime mortgages represented an average of 8 percent of all loans in the 2001-2003 period, rising to an average of 20 percent in the 2005-2006 period, when over 80 percent of such mortgages were securitised with an average value of approximately $450 billion per annum (Randdal, 2007). This increase supports one of Minsky’s argument which is that “finance allows for a much faster growth of income and capital accumulation but, at the same time, increases the stock of debt” (Gatti & Gallegati, 1990).

According to the Congressional Budget Office of the United States, sub-prime mortgages account for more than half of expected credit losses and are now forecast in the range of $300 billion to $400 billion. However, since 2005 after rates have been counted for two years, this amount rose to roughly $1.5 trillion (2008, 23). If house prices fell by 30 percent, these figures would double, but not including additional defaults. In addition, there has been an unexpected increase in prime mortgage defaults that could bring the total credit losses to nearly $900 billion as a high estimate (Kregel, 2008). These dynamic figures have shown that the losses would be distributed among borrowers, creditors and banks. This phenomena is reflected in the theory of debt-deflation or over-indebtedness in which “the rise of debt-deflation can only happen while investment and capital assets are financed as economies have the benefits of an extended period of good times” (Minsky, 1994).

Institutional Structure
The financial instability hypothesis also supports the credit view of money and finance by Joseph Schumpeter (1934). In 1911 Schumpeter argued that the services provided by financial intermediaries , which are mobilising savings, evaluating projects, managing risk, monitoring managers, and facilitating transactions, are essential for technological innovation and economic development (King & Levine, 1993).

Schumpeter characterised the banker as the ephor of developing capitalist economies. At an earlier meeting of the Schumpeter Society, Minsky characterised central bankers as the “ephor of the ephors” of capitalism (Minsky, 1994). In 1797 – 1800, the Bank of England was suspended because of the war of inflation in which the Bank of England had obligations to cash notes in gold, which resulted in a great impact on prices and foreign exchange rates (Schumpeter, 1939).

According to Schumpeter, Keynes, in order to overcome the malfunctions of capitalism, broke down the conventional belief that saving, as a part of the bourgeois scheme of life, and unequal distribution of income and wealth, as a necessary evil for progress, were social virtues. This was, Schumpeter declared, the essence of the Keynesian Revolution. However, this renouncement of support for these values was the most basic non-economic factor leading to the fall of capitalism (Moss & Schumpeter, 1996).

There is no doubt that Minsky took some lessons from Joseph Schumpeter’s theories on credit, money and finance, as Minsky’s basic ideas to construct institutional structures reflects legislation, administrative actions, and the evolution of institutions and traditions that represented the past behaviour of market participants. The legislation reflects the understanding of the economy as maintaining economic theory, which was a rule among policy establishment at the time the institutions were created (Minsky, 1994). Minsky also emphasised that law and policy makers needed to be aware of institutional evolution which means sometimes bankers change their monetary policy which can lead to serious disruptions in investment and profit flows (Minsky, 1991).

Conclusion
This essay has presented and discussed a number of elements of economist Minsky’s theories on capitalist economy and economic systems in general. Minsky’s basic hypothesis is that capitalist economies are fragile, unstable and unbalanced. When capitalist economy gets to a stage that it is basically financed by debt, as per his financial instability hypothesis, the risk of plunging into crisis becomes great. Capitalist economic systems increased greatly in instability and fragility since 1987 with the collapse of securitisation of the home mortgage market. Minsky’s theories are therefore intimately related to the global financial system collapse two years ago, which was a cause of over-indebtedness, particularly in the sub-prime mortgage market in the United States.

In particular this essay has discussed elements of Minsky’s “financial instability hypothesis” and how it relates to the recent financial crisis. The two main elements that have been presented are that of “debt-deflations” and “cushions of safety”, backed up by a discussion of the related elements of “Ponzi Pyramids” and “Structural Institutions”. The paper has discussed how the evolution of Minsky’s theories have been grounded in the original theories on economic systems and capitalism of John Maynard Keynes and Adam Smith, one of which was critical of and the other in favour of capitalism. Essentially, Minsky sides with Keynes in purporting that a capitalist system must be grounded by regulation and intervention, to prevent it from becoming unstable. A market which is allowed to reign free is inherently unstable, leading to crisis.

In assessing how Minsky’s theories relate to the recent global economic crisis, a discussion of the elements of hedge, speculative and ponzi finance have been used to support the theory of debt-deflation, related to his financial instability hypothesis. The conclusion here is that indebtedness, an essential element of free market capitalist economy, is intimately related to the collapse of the market in the United States in 2008. Cushions of safety, another element of Minsky’s financial instability theory, has also been shown in this paper to be related to a neoliberal economic model that warrants no regulation or interference and hence the market is free to govern as it likes, resulting in a lack of any form of security should things go wrong, as happened in the recent financial crisis. Finally, institutional structures were discussed as one aspect of Minsky’s financial instability hypothesis. As a result of the above detailed analysis, it can be concluded that Minsky’s economic theory of financial instability can be related to much of what occurred in the 2008 global financial crisis, in particular the sub-prime mortgage market collapse in the United States.  

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