The core relationship of the financial instability hypothesis is based around this debt relationship. Banks act not only as middlemen. Firms are not just trading with other productive firms, but there is a model where the financial sector is a profit-seeking entity itself, and these “merchants of debt” (6) do what they can to innovate the products they sell.
Minsky described three different kinds of debt relationships as time passes. The first is “Hedge Financing,” where the debt can be paid by the borrowers with working cash flows. This is the most sustainable model. Firms borrow and they can pay off their debt easily with the money they get in the bank from operations. The second debt relationship is what he called “Speculative Finance.” In this relationship, the borrower is a little more stretched. They can afford to pay the interest, but the only the interest is paid out of cash flows, but the principle is not paid down. Net debt for the firm therefore does not decrease but stays constant. Finally, in the third form we reach what Minsky identifies as “Ponzi” units. If a borrower is in this phase of the debt relationship, it means that their cash flows are not enough to pay any of the debt. Net debt is growing as even the interest payments swamp the absolute size of incoming cash flows. The only ways a firm would be able to pay off their liabilities once the Ponzi phase is reached is to either keep borrowing so that your new loans pay off your old loans or to sell off your assets to generate cash to pay the debt coming due (7). For Minsky, there are two modes of being for the financial system. One is that the hedge finance relationship can be predominate, and the economic system will be stable. The second mode is that continued stability sows the seeds for a movement from a stable system to an unstable one where Ponzi financing predominates. When these Ponzi modes predominate in the system, it is then that set the stage for the crash. For Minsky, as borrowing increases growth by continued leverage this helps triggers inflation which in turn pulls once more stable structures into the Ponzi mode. Once more and more firms are pulled into Ponzi mode, growth cannot continue forever. One firm will not be able to continue borrowing, and they will be forced to liquidate assets to be able to pay off the debt that is coming due. This becomes a problem because once liquidation is forced on the most highly leveraged, then they will help crash asset values as other firms will need to in turn liquidate their holdings to be able to make their debt payments (8). Thus, long steady growth develops the conditions for the crash.
The Minsky Financial Instability Hypothesis is a compelling enough model that Charles Kindleberger used it to map out what he described as a typical crisis in his book “Manias, Panics, and Crashes, where he described the tipping point: “The panic feeds on itself until prices have declined so far and have become so low that investors are tempted to buy the less liquid assets, or until trade in the assets is stopped by setting limits on price declines, shutting down exchanges or otherwise closing trading, or a lender of last resort succeeds in convincing investors that money will be made available in the amounts needed to meet the for cash and that hence security prices will no longer decline because of a shortage of liquidity” (32-3). In his book Kindleberger uses the chapter where he outlines Minsky to talk about a generalized crisis, one that can be modeled and of use to economists. He balances that up against the historians, who want to look at the specifics of each. Personally, my take is somewhere in the middle because my interest in the discipline of economics was derived through personal experience of the crisis, and then I abstracted from the part to try to understand the whole – a journey still in progress.
The Financial Instability Hypothesis came back on the radar because, so few prominent economists saw the crash coming. Pre-2007, dialogue at the macro-level was about the so-called “Great Moderation”. The crisis caught enough people off guard there is a story about the Queen walking down to the London School of Economics and asking the learned Mandarins there “Why did no one see this coming?”. The problem was that the people who saw it coming were not part of the right schools and did not have influence with the right journalists or even their professional peers. So that when someone wanted to talk about the financial instability hypothesis after the crisis, Minsky’s books were out of print. There is no prize for calling recessions in the profession. There are financial gains to be made, but even Michael Lewis in “The Big Short” only found a handful who were able to profit in the market by seeing the particulars that Minsky outlined in general form in his paper. As Keynes said, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” The Great Moderation in fact hid the move from hedge finance to the Ponzi finance that banks and other financial institutions were undertaking, and it went on right up until the point the housing market peaked in 2006 and then slowly as some funds closed in 2007 and then all at once as the crisis came into the real world in 2008. Hopefully, Minsky’s books will not go out of print again, and people will not forget the lessons of 2008. I have my doubt. Looking at long waves, we see major crises happen every seventy years or so. I have my own hypothesis that enough people die off to lose the fear, so crises are just stories in books. Our children will feel the fear again in their lifetimes.
Cited:
Aliber, R. Z., & Kindleberger, C. P. (2015). Manias, panics and crashes: A history of financial crises. Houndmills, Basingstoke, Hampshire: Palgrave Macmillan.
Minsky, Hyman P. The Financial Instability Hypothesis (1992) The Jerome Levy Economics Institute of Bard College
To get three categories out of this model, one of the categories needs to be razor thin. It's like classifying numbers into the three categories positive, zero, and negative. What your friend Minsky describes as speculative finance, or paying all of the interest and none of the principal, sounds suspiciously like the actually-advertised (prior to the crisis) "interest-only mortgages". Since the middle zone is razor thin, only a little push (say a dip in the value of the mortgaged property) is necessary to push the creditor-debtor relationship into negative amortization, or Ponzi, territory. Supposedly a disruption such as a cash windfall could push the system into positive amortization, but another tactic associated with the age of aggressive mortgage marketing was the pre-payment penalty. I assume this ties into the mushrooming of derivatives and other options. Perhaps the pre-payment penalties were seen as covering someone's downside (insurance against refinancing?) One person's upside is another person's downside. Risk doesn't get managed, it gets shifted, and somebody always gets shafted.
ReplyDeleteI would suggest that stability should be associated with speculative, not hedge, financing. Equilibrium in most matters implies zeroness, not positivity or negativity. Hedge financing as described here induces more warm fuzzy feelings than speculative, because it describes (normatively?) where we'd all like to be, which is in the black. But one person's black is another person's red. We can't have a world in which all nations are net exporters, and we can't have a society in which each person produces more than they consume, or a town in which all the children are above average.