Monday, May 17, 2010

Minsky and the Financial Crisis.

Hyman P. Minsky’s “Financial Instability Hypothesis” has received renewed interest in light of the current malaise. Minsky attempted to formulate an endogenous theory of financial instability and in this pursuit he focused primarily on income-debt relations and the negotiation between bankers and businessman. This hypothesis is predicated upon the existence of an intricate and highly evolved financial system operating within a capitalist economy. Based upon this assumption Minsky’s hypothesis is a partial explanation of the current crisis. The scope of analysis presented in the hypothesis does not venture to explain the interconnections between the financial sector and the real economy. The increased relative importance of finance and the process of financialization that underlay the current financial crisis are completely outside of the parameters of the financial instability hypothesis. From the perspective of policy formation, explanations of the crisis in terms of both its proximal and ultimate causes inform efforts for an adequate response. To follow this line of enquiry; Minsky’s financial instability hypothesis will be given fuller exposition with reference to different interpretations and extrapolations of his perspective, and moreover the hypothesis will be evaluated as an explanation of the current crisis. Finally, the policy implications of Minsky’s hypothesis will be analysed in light of its explanatory power and in relation to other explanations of the proximal and ultimate causes of the crisis.

Minsky stated that his financial instability hypothesis was developed in large part as an alternative interpretation of John Maynard Keynes’ “General Theory”. He borrowed from economic literature informed by the experience of the great depression and concerned with the nature of boom and bust cycles. Famously, Minsky asked the question: “can ‘it’ happen again?” He answered that ‘it’, another great depression, was unlikely to occur given the role of central banks in the monetary system. However, consistent with the influence of Keynes, Minsky remained concerned with role of expectations and uncertainty in the economy and the possibility of these variables contributing to instability. The insistence of instability stands in stark contrast to the vision of financial markets held by supporters of the “efficient market hypothesis” who conceive of rational actors pushing asset-prices toward their “fundamental value”. From within the Keynesian tradition, Minsky questioned the extent to which financial actors can be construed as rational actors and instead characterized actors as subject to certain attitudinal dispositions and mentalities that affect their decision making processes.

Similarly, Fisher Black, who co-derived the Black-Scholes formula to price financial derivatives, once made the point that: “expectations follow no rational rules”. Minsky’s hypothesis is therefore based upon a psychological understanding of individual actors and their collective dynamics. Alongside of the influence of Keynes, Minsky incorporated the work of Charles Kindleberger on the five stages of speculative bubbles into his financial instability hypothesis. Importantly, the hypothesis is not advanced on an appreciation of subjective elements alone and incorporates an interpretation of over-indebtedness developed by Irving Fisher and the credit view of money developed by Joseph A. Schumpeter. Thus, the central nexus of Minsky’s financial instability hypothesis is the relationship between income, credit, debt and the ability of cash flows to sustain the given level of liability. This relationship is, of course, dependent upon the expectations and impressions of bankers and businessman.

In expansionary economic conditions, where the inducement to invest is strong, businessman are willing to take on debt to finance their investments. Fisher argued that an appetite for debt-fueled investment in buoyant economic conditions leads to economic crisis. Technological progress and new inventions opened up investment opportunities that were expected to return rates of profit in excess of interest rates and the cost of money. Levels of debt increased dramatically; however, the accumulation of debt is not the single factor that results in over-indebtedness. In reference to the early 1970s, David Laibman noted that debt to equity ratios were marginally above 1929 levels and this was taken to be a sound basis to predict an imminent collapse of the financial system. Despite minor recessions and tremors, no major economic downturn occurred within the U.S economy until four decades later. Obviously, the sheer quantitative dimension of debt is not sufficient to explain cyclical downturns and economic crashes. Both Fisher and Minsky emphasized the crucial relationship between debt and income, Minsky took this a step further and developed a tripartite typology of debt-income structures for financial units.

The first debt-income structures for financial units, “hedge financing units”, are characterised by the ability of the unit to realise all of their payment obligations. Higher rates of equity to debt are indicative of hedge financing units. Secondly, “speculative” units are able to meet commitments on interest repayments, but are unable to pay down the principle of the debt from their incoming cash flows. Thirdly, ponzi units are unable to finance either interest repayments or repayments on the principle with exiting cash flows. Ponzi units can only be sustained from the liquidation of assets or the leveraging of more debt, both of which can only ever be stop gap measures. Financial systems that are dominated by hedge units are said by Minsky to be “equilibrium seeking”, while systems characterised by significant portions of ponzi units are said by Minsky to be “deviation amplifying”. Minsky argued that, when conditions of prosperity continue for an extended period of time, the financial system undergoes a qualitative transformation from hedge finance to unsustainable finance dominated by speculative and ponzi units. This transformation is affected largely by the prior success of finance and its effects on the expectations of financial actors.

As Fisher noted, the primary cause of over-indebtedness that underlay the great depression was the existence of good investment opportunities. The abundance of investment opportunities in the 1920s led to financial euphoria and over-confidence, this in turn led to over-indebtedness on behalf of entrepreneurs seeking profitable investment. In Minsky’s terms, hedge finance geared toward the advancement of capital to business operations became increasingly speculative and unsustainable Ponzi finance. Once financial actors realised that the system had become unable to validate current debt levels there was a fall in confidence and the process of debt-deflation and economic contraction set in. The process by which hedge finance is transformed into Ponzi finance via the evolution of expectations has been labeled the “basic Minsky cycle” by Thomas Palley. More controversially, Palley discussed the nature of a “super Minsky cycle” that links optimism within the financial market itself to increased optimism within regulatory institutions. Both cycles help explain the financial dynamics that led to the collapse of the sub-prime mortgage market in early 2007. Whilst the first cycle has gained wide acceptance, the latter cycle is controversial because its relation to Minsky’s hypothesis has been questioned . Despite this, the super cycle thesis advanced by Palley is clearly inspired by Minsky’s financial instability hypothesis and helps to broaden it perspective with regards to financial regulation.

John Bellamy Foster and Robert W. McChesney have argued that by introducing the notion of a “super cycle”, Palley has converted Minsky into “a theorist of a financial long wave”. They contend however, that it is precisely in terms of long-run trends that Minsky’s hypothesis has least explanatory power. To leave aside Foster and McChesny’s criticisms of Minsky’s short-run perspective for now, the extent to which Minsky’s hypothesis adequately explains the proximal causes of the crisis has been questioned. Jan Kregel has highlighted two important short falls of Minsky’s hypothesis when applied to the recent crisis. Firstly, the primacy of entrepreneur-banker negotiations has shifted since the 1980s with increased importance of proprietary trading, and secondly given this, the mechanism by which the financial system degenerated into Ponzi finance was not declining margins of error between liabilities and cash flows as classically outlined by Minsky, but new models of banking operations that were inherently risk-riddled. Kregel placed central importance on the “originate and distribute” methods that bank employed leading up to the crisis . To accrue quick profits by fees and commissions, banks would form new securitised assets and sell them on. The ‘originate and distribute’ model involved a complex set of institutional relationships that Peter Gowan labeled the “new wall street system” that facilitated excessive levels of leveraging via a series of adjunct financial institutions that have been characterised as a “shadow banking system”.

The shadow banking system linked traditional commercial and investment banks to hedge funds and private equity funds. These along with other structured investment vehicle (SIV) provided the context for new financial instruments that hid liabilities and risk allowing for increased leveraging and regulatory escape. Not surprisingly, Minsky had noted the possibility that creative accounting can mask the transition from hedge to ponzi finance. New forms of financial instrument that developed alongside the shadow banking system help facilitate such creative accounting. Credit derivatives, in the form of Collateralized Debt Obligations (CDOs) and Credit Default Swaps (CDSs), were two such financial instruments that caused much of the damage to the financial system. Between 2001 and 2006 the total nominal value of sub-prime mortgages increased from $160 billion to $ 600 billion . Banks packaged these loans into CDOs and sold them over the counter (OTC) without a market mechanism to determine the CDOs ‘fundamental value’. Rating agencies, who underwrite CDOs for a fee, would for an additional fee rate these credit derivatives as “AAA”. The complexity of CDOs and the OTC nature of the transitions meant that the financial instruments are extremely difficult to price effectively. This is compounded by the fact that unlike traditional commodity based derivatives the notional value of mortgage tranches was not determinable as the components of any given CDO were not know. It is clear that the over-investment and over-indebtedness that preceded the great depression is qualitatively different than that which precipitated the latest financial crisis. Minsky’s insistence on the primacy of banker-businessman negotiations and the steady decline of margins of error in the transition from hedge to ponzi finance are brought into contestation when applied to the financial crisis of the late 2000s. However, Minsky’s general theorem that extended periods of prosperity bred optimism that lead to over-indebtedness and speculative manias remains valid. Allen Greenspan’s reference to “irrational exuberance” in 1996 underscores this point. The stock market bubble to which Greenspan referred to was overcome by the bubble within real-estate and the financial system layered one problem upon another. While Minsky’s hypothesis remains somewhat helpful for an explanation of the proximal causes of the crisis, he remains silent on long-term trends and the nature of financialization that underlay the financial crisis.

The quantitative dimension of the crisis and its consequences can only be understood with relation to the financialization trend in the U.S economy from the 1970s and with increasing velocity through the 1990s. By the 1990s, financial profits were far in advance of non-financial profits. Keynes’ concern that: “speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirl-pool of speculation” is brought into play when the financial sector grows out of proportion with the real economy. Two general theses have emerged to explain the growth of finance and its correlation with stagnation in the real economy. The issue is that of precedence, either financialization causes stagnation in the real economy by luring capital away from productive enterprise, or a lack of real economy investment opportunities leads to the development of finance to employ surplus capital and generate profits. If the latter, the stagnation thesis, is accepted over the financialization thesis the prognosis is dire. Capital accumulation has reached a point of saturation and the possibilities of productive real economy investments have become scarce. Recurrent financial crises will emerge from the attempt of capital to overcome this underlying over-accumulation. At best, reform can lead only to momentary relief. However, if the financialization thesis is adopted, re-regulation of the financial system is possible and can limit its demonstrated proclivity to instability. The financial instrument that hid liabilities and allowed for the half-conscious slip into ponzi finance could be addressed, along with the regulation of bank and non-bank financial institutions. However, Palley’s extension of Minsky’s financial instability thesis demonstrated that optimism within the financial market can lead to unfounded optimism within the regulatory institutions and therefore the long-term ability to overcome financial instability is brought into question.

Minsky formulated a theory of endogenous financial instability. To construct his hypothesis he drew on the Keynesian tradition, the theories of bubbles developed by Charles Kindleberger, Schumpeter’s credit theory of money and Irving Fisher’s debt-deflation theory of the great depression. He was concerned with issue of the possibility of future great depressions. Minsky’s policy recommendations fit within this tradition and focus on the central bank as lender of last resort and the importance of reflation to fight debt-deflation processes that can lead to sharp contractions in economic activity. Like Fisher, Minsky sought to analyse the financial system in terms of income-debt relations and developed his typology of financial units. He argued that on the basis of prior successes and the extrapolation of these trends, sound financial systems based predominantly around hedge finance can be transformed into speculative and ponzi finance. In regards to the latest financial crisis, the precise mechanisms outlined by Minsky have less applicability than to prior crises. This is linked with institutional changes that occurred in the banking system during the 1980s and the increased importance of proprietary trading and the interconnected web of institutions that formed the shadow banking system that obscured the health of the financial system. On the proximal causes of the financial crisis, Minsky’s hypothesis is moderately useful. Given its endogenous character, the deeper causes of the financial crisis and the process of financialization are wholly unexplained. The nature of such trends and their importance for policy formation are not appreciated by Minsky. Minsky’s hypothesis is partially vindicated by the financial crisis and stands to caution financial operatives and regulators of the continued relevance of uncertainty and expectations in financial markets. 

Written by Mathew Toll.


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Mathew Toll said...

Is it just me, or can you think of Minsky like modern day Greek tragedy? Hubris and the limit is surpassed, nemesis steps in smashes shit up. It’s like bankers and brokers should have the myth of Icarus tattooed to the inside of their heads?

Anonymous said...

thats funny as mat


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