Financial Instability Hypothesis
Financial Instability Hypothesis
The American economist Hyman P. Minsky (1919–1996) set the realist criteria that, for a macroeconomic theory to be taken seriously, it had to make a depression “one of the possible states in which our type of capitalist economy can find itself” (1982, p. 5), and also explain why no such event had happened since the 1930s. Neoclassical theories failed that test, and Minsky devised the financial instability hypothesis (FIH) as an alternative. The hypothesis was based on an interpretation of chapter 12 of John Maynard Keynes’s (1883–1946) General Theory of Employment, Interest, and Money (1936).
The FIH sees finance as both essential to the market economy and the source of debt-financed boom-bust cycles. This cyclical process has a secular consequence, as money borrowed during booms generates repayment obligations that have to be fulfilled during slumps. As a result, debt levels ratchet up over a sequence of cycles, culminating in a debt-deflation. This regularity of the nineteenth century has not occurred since the Great Depression of the 1930s because of the development of “big government” and Federal Reserve intervention.
Unlike most economic models, the FIH is grounded in historical time, with an uncertain future. It commences with the economy having just stabilized after a previous debt-induced crisis, and with investors and lenders that are consequently conservative in project valuation. As a result, given the stable economic conditions, most projects succeed. This surprises investors and financiers alike, leading both to revise their expectations upward. Stable economic times thus cause rising expectations—“stability is destabilizing,” in one of Minsky’s most apt aphorisms— and these expectations are shared. Information asymmetry, a popular neoclassical explanation for credit problems, is of little importance.
Rising expectations increase investment, the finance for which is forthcoming from equally optimistic banks, so that growing investment and endogenously expanding credit push the economy into a boom. Asset prices rise, causing them to diverge significantly from commodity prices. Expectations eventually become euphoric, setting the scene for the boom to unravel as the shift in expectations changes the economy’s investment profile.
A hedge climate, where investments are expected to meet all repayment obligations out of cash flow, gives way to a speculative one, where principal must be rolled over. Ultimately, Ponzi finance becomes prominent: investments that can only succeed if the assets can be sold on a rising market.
The economy’s fragility thus rises, and even a small knock can bring it down. Expectations collapse, investment ceases, endogenous credit creation ends, and the economy enters a slump. What happens next depends on the institutional structure of the economy. In a pure market economy with a high debt to output level or commodity price deflation, the economy will enter a depression. In a modern mixed economy, cash flow from countercyclical government spending enables firms to repay debts during a slump, while Reserve Bank lender-of-last-resort actions prevent runs on financial institutions. The cycle continues, and a prolonged slump is avoided.
Minsky’s theory so suits the U.S. economic record that it sounds like a description, rather than a theory. However, a theory it is, amenable to mathematical expression in differential equation models, and consonant with empirical findings on the U.S. trade cycle.
SEE ALSO Business Cycles, Political ; Business Cycles, Real ; Business Cycles, Theories ; Depression, Economic ; Economic Crises ; Economics, Neoclassical ; Expectations ; Long Waves ; Lucas Critique ; Panics ; Ponzi Scheme ; Recession ; Say’s Law ; Shocks
Bellofiore, Riccardo, and Piero Ferri, eds. 2001. Financial Keynesianism and Market Instability: The Economic Legacy of Hyman Minsky. Vols. 1 and 2. Aldershot, U.K.: Edward Elgar.
Keen, Steve. 1995. Finance and Economic Breakdown: Modeling Minsky’s Financial Instability Hypothesis. Journal of Post Keynesian Economics 17 (4): 607–635.
Minsky, Hyman P. 1982. Can “It” Happen Again? Essays on Instability and Finance. Armonk, NY: Sharpe.