Hyman Minsky was an American economist and a professor of economics at Washington University in St. Louis. Minsky spent his life on the margins of economics but his ideas gained currency with the 2007-08 financial crisis. To many, it seemed to offer one of the most plausible accounts of why it had happened.
Minsky wrote in 1974:
“A fundamental characteristic of our economy is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”
Minsky argued that the swings and the booms and busts that can accompany the cycle of business are inevitable in a so-called free market economy – unless government steps in to control them, through regulation, central bank action and other tools.
Minsky’s main idea is so simple that it could fit on a T-shirt, with just three words: “Stability is destabilizing.”
Most macro-economists work with what they call “equilibrium models” – the idea is that a modern market economy is fundamentally stable. That is not to say nothing ever changes but it grows in a steady way.
To generate an economic crisis or a sudden boom some sort of external shock has to occur – whether that be a rise in oil prices, a war or the invention of the internet.
Minsky disagreed. He thought that the system itself could generate shocks through its own internal dynamics. He believed that during periods of economic stability, banks, firms and other economic agents become complacent.
They assume that the good times will keep on going and begin to take ever greater risks in pursuit of profit. So the seeds of the next crisis are sown in the good time.
Minsky had a theory, the “financial instability hypothesis”, arguing that lending goes through three distinct stages. He dubbed these the Hedge, the Speculative and the Ponzi stages, after financial fraudster Charles Ponzi.
In the first stage, soon after a crisis, banks and borrowers are cautious. Loans are made in modest amounts and the borrower can afford to repay both the initial principal and the interest.
As confidence rises banks begin to make loans in which the borrower can only afford to pay the interest. Usually this loan is against an asset which is rising in value. Finally, when the previous crisis is a distant memory, we reach the final stage – Ponzi finance. At this point banks make loans to firms and households that can afford to pay neither the interest nor the principal. Again this is underpinned by a belief that asset prices will rise.
The easiest way to understand is to think of a typical mortgage. Hedge finance means a normal capital repayment loan, speculative finance is more akin to an interest-only loan and then Ponzi finance is something beyond even this. It is like getting a mortgage, making no payments at all for a few years and then hoping the value of the house has gone up enough that its sale can cover the initial loan and all the missed payments. You can see that the model is a pretty good description of the kind of lending that led to the financial crisis.
The “Minsky moment”, a term coined by later economists, is the moment when the whole house of cards falls down. Ponzi finance is underpinned by rising asset prices and when asset prices eventually start to fall then borrowers and banks realize there is debt in the system that can never be paid off. People rush to sell assets causing an even larger fall in prices.
It is like the moment that a cartoon character runs off a cliff. They keep on running for a while, still believing they’re on solid ground. But then there’s a moment of sudden realization – the Minsky moment – when they look down and see nothing but thin air. Then they plummet to the ground, and that’s the crisis and crash of 2008.
Minsky understood that banks were not just simple intermediaries moving money through the system but profit-making institutions, with an incentive to increase lending. This is part of the mechanism that makes economies unstable.
Thus, financial crises are built into the system itself. The “free-market” system is an illusion which produces cyclical catastrophes.
Thanks for reading,