(iii) Minsky: Can ‘It’ Happen Again?
Hyman Minsky's ‘Financial Instability Hypothesis’ has become a unifying vision in post-Keynesian economics, crystallising the many differences between this school's approach and the neoclassical model. As he is still relatively unfamiliar to neoclassical economists, it is important to set out his analysis at length here. Minsky's guiding principles were first that a model of capitalism must be able to generate a depression as one of its possible outcomes:
Can ‘It’—a Great Depression—happen again? And if ‘It’ can happen, why didn't ‘It’ occur in the years since World War II?… To answer these questions it is necessary to have an economic theory which makes great depressions one of the possible states in which our type of capitalist economy can find itself. (Minsky, 1982, p. 5)
and second that capitalism is inherently unstable:
The alternative polar view, which I call unreconstructed Keynesian, is that capitalism is inherently flawed, being prone to booms, crises, and depressions. This instability, in my view, is due to characteristics the financial system must possess if it is to be consistent with full-blown capitalism. Such a financial system will be capable of both generating signals that induce an accelerating desire to invest and of financing that accelerating investment. (Minsky, 1969, 1982, p. 279)
Minsky's verbal model of a financial cycle begins at a time when the economy is doing well (the rate of economic growth equals or exceeds that needed to reduce unemployment), but firms are conservative in their portfolio management (debt to equity ratios are low and profit to interest cover is high), and this conservatism is shared by banks, who are only willing to fund cash-flow shortfalls or low-risk investments.
The cause of this high and universally practised risk aversion is the memory of a not too distant system-wide financial failure, when many investment projects foundered, many firms could not finance their borrowings and many banks had to write off bad debts. Because of this recent experience, both sides of the borrowing relationship prefer extremely conservative estimates of prospective cash flows: their risk premiums are very high.
However, the combination of a growing economy and conservatively financed investment means that most projects succeed. Two things gradually become evident to managers and bankers: ‘Existing debts are easily validated and units that were heavily in debt prospered: it pays to lever’ (Minsky, 1982, p. 65). As a result, both managers and bankers come to regard the previously accepted risk premium as excessive. Investment projects are evaluated using less conservative estimates of prospective cash flows, so that with these rising expectations go rising investment and asset prices. The general decline in risk aversion, therefore, sets off both growth in investment and exponential growth in the price level of assets, which is the foundation of both the boom and its eventual collapse.
More external finance is needed to fund the increased level of investment and the speculative purchase of assets, and these external funds are forthcoming because the banking sector shares the increased optimism of investors (Minsky, 1982; p. 121). The accepted debt to equity ratio rises, liquidity decreases and the growth of credit accelerates.
This marks the beginning of what Minsky calls ‘the euphoric economy’ (Minsky, 1982, pp. 120–124), where both lenders and borrowers believe that the future is assured, and therefore that most investments will succeed. Asset prices are revalued upward as previous valuations are perceived to be based on mistakenly conservative grounds. Highly liquid, low-yielding financial instruments are devalued, leading to a rise in the interest rates offered by them as their purveyors fight to retain market share.
Financial institutions now accept liability structures for both themselves and their customers ‘that, in a more sober expectational climate, they would have rejected’ (Minsky, 1982, p. 123). The liquidity of firms is simultaneously reduced by the rise in debt to equity ratios, making firms more susceptible to increased interest rates. The general decrease in liquidity and the rise in interest paid on highly liquid instruments trigger a market-based increase in the interest rate, even without any attempt by monetary authorities to control the boom. However, the increased cost of credit does little to temper the boom, as anticipated yields from speculative investments normally far exceed prevailing interest rates, leading to a decline in the elasticity of demand for credit with respect to interest rates.
The condition of euphoria also permits the development the Ponzi financier (Minsky, 1982; pp. 70, 115; Galbraith, 1954, pp. 4–5). These capitalists are inherently insolvent, but profit by trading assets on a rising market, and must incur significant debt in the process:
A Ponzi finance unit is a speculative financing unit for which the income component of the near term cash flows falls short of the near term interest payments on debt so that for some time in the future the outstanding debt will grow due to interest on existing debt… Ponzi units can fulfill their payment commitments on debts only by borrowing (or disposing of assets)… a Ponzi unit must increase its outstanding debts. (Minsky, 1982, p. 24)
The servicing costs for Ponzi debtors exceed the cash flows of the businesses they own, but the capital appreciation they anticipate far exceeds their debt servicing costs. They therefore play an important role in increasing the fragility of the system to a reversal in the growth of asset values.
Rising interest rates and increasing debt to equity ratios eventually affect the viability of many business activities, reducing the interest rate cover, turning projects that were originally conservatively funded into speculative ones, and making ones that were speculative ‘Ponzi’. Such businesses will find themselves having to sell assets to finance their debt servicing – and this entry of new sellers into the market for assets pricks the exponential growth of asset prices. With the price boom checked, Ponzi financiers now find themselves with assets that can no longer be traded at a profit, and levels of debt that cannot be serviced from the cash flows of the businesses they now control. Banks that financed these assets purchases now find that their leading customers can no longer pay their debts – and this realisation leads initially to a further bank-driven increase in interest rates. Liquidity is suddenly much more highly prized; holders of illiquid assets attempt to sell them in return for liquidity. The asset market becomes flooded and the euphoria becomes a panic, the boom becomes a slump.
As the boom collapses, the fundamental problem facing the economy is one of excessive divergence between the debts incurred to purchase assets, and the cash flows generated by them – with those cash flows depending on both the level of investment and the rate of inflation.
The level of investment has collapsed in the aftermath of the boom, leaving only two forces that can bring asset prices and cash flows back into harmony: asset market deflation or current goods inflation. This dilemma is the foundation of Minsky's iconoclastic perception of the role of inflation and his explanation for the stagflation of the 1970s and early 1980s.
Minsky argues that if the rate of inflation is high at the time of the crisis, then though the collapse of the boom causes investment to slump and economic growth to falter, rising cash flows rapidly enable the repayment of debt incurred during the boom. The economy can thus emerge from the crisis with diminished growth and high inflation, but few bankruptcies and a sustained decrease in liquidity. Thus, though this course involves the twin ‘bads’ of inflation and initially low growth, it is a self-correcting mechanism in that a prolonged slump is avoided.
However, the conditions are soon re-established for the cycle to repeat itself, and the avoidance of a true calamity is likely to lead to a secular decrease in liquidity preference.
If the rate of inflation is low at the time of the crisis, then cash flows will remain inadequate relative to the debt structures in place. Firms whose interest bills exceed their cash flows will be forced to undertake extreme measures: they will have to sell assets, attempt to increase their cash flows (at the expense of their competitors) by cutting their margins, or go bankrupt. In contrast to the inflationary course, all three classes of action tend to further depress the current price level, thus at least partially exacerbating the original imbalance. The asset price deflation route is, therefore, not self-correcting but rather self-reinforcing, and is Minsky's explanation of a depression.
The above sketch basically describes Minsky's perception of an economy in the absence of a government sector. With big government, the picture changes in two ways, because of fiscal deficits and Reserve Bank interventions. With a developed social security system, the collapse in cash flows that occurs when a boom becomes a panic will be at least partly ameliorated by a rise in government spending – the classic ‘automatic stabilisers’, though this time seen in a more monetary light. The collapse in credit can also be tempered or even reversed by rapid action by the Reserve Bank to increase liquidity.
Hence, although Minsky argued that financial instability was inevitable, he argued that depressions could be avoided by a combination of deficits resulting from ‘Big Government’ and ‘Lender of Last Resort’ interventions by the Central Bank – so long as, in addition, we ‘establish and enforce a ‘good financial society’ in which the tendency by business and bankers to engage in speculative finance is constrained’ (Minsky, 1977, 1982, p. 69).