A Review of Hyman Minsky's 'Financial Instability Hypothesis in 'Can "It" Happen Again?' [PART II]

- Review By Chinedu Okoye 

Household Holdings of Financial Securities:

Household financing of securities is a often regarded as a Ponzi financing if interest payments exceed the dividend payments expected. They are seen as speculative when expected dividend/income ratios exceed interest rates. 

Stock market financing can only be seen as hedge, when "the term to maturity of the debt is so long that the borrowing unit does not have to refinance it's position".

The question now arises "why would a rational banker finance such a security holding?" And the "obvious answer" Minsky points is the dividend yield and price appreciation expectations.

Household financing of securities can be destabilizing to the economy if there is a significant portion of Ponzi financing posture involved, relative to the whole. This is where dividends fall short of interest payments and the hope for redemption is an eventual price appreciation.

A speculative boom is exemplified by a growth in Ponzi financing of assets by households, and this can induce a rise in output prices —as debt costs increases with demand for money.

Since households consumption can also be financed by debts a build up of consumer debt will also lead to price increases (of consumer goods), and a high consumption to income ratio. A reduction of these debts, by households would lead to a low consumption to income ratio.

 

Government:

Just like private units (households and businesses), governments also have payment commitments in debts. This is validated by a combination of tax payments and new borrowing. Government units fall in the form of speculative units because they roll over short-term debt and long-term future expected cashflows are anticipated to outweigh current outstanding debts.

Just as well, if expected taxes fall,  or current operational spending increase rapidly (for political or other non economic reasons), roll-over, restructuring, or solvency issues can arise. Higher interest on debt can turn government units into Ponzi units.

Hedge, speculative and Ponzi finance "defines both sets of markets that need to be functioning for payment commitments to be validated and the potential sources of difficulty."

The financing difficulties of a hedge financing unit does not lead to or become a source of overall market instability. But this depends on the stability of income sources for if income deteriorates, the units can become speculative and even Ponzi which then "amplifies disturbances" and affects the overall economic and financial stability.

As the portion of hedge financing units decrease, the propensity for economic disturbances increase, and the financial structure becomes more fragile. Of all units mentioned, the most likely to cause an overall crisis/ instability is the business sector.

On why Household ad Governments are Excluded from Primary causes of Instability:

Household debts are majorly consumption or mortgages which fall under hedge financing, because it satisfies the conditions for that categorization.

The payments are fully armortized; the epected near term income exceeds near term payments, and in the case of mortgage, an asset is involved that provides a level of security for it can be liquidated upon default. [Think car loans, mortgages, where if the borrower defaults, the asset can be recovered by the lender, providing a healthy margin of safety, with little capital losses for the lender]

Government debts are also armortized, but short term payments can exceed shorterm revenue, a shortfall that can be financed by debts, making it also a speculative unit in that regard.

[In the Zero Equilibrium view, local denominated government debt instruments—Treasury bills, and medium-term duration bonds—are hedged, as the country cannot run out of its own currency and 'real constraints' are minimal.

Longer-term duration bonds and foreign currency denominated bonds, however, are speculative financing postures. This makes the government a hybrid financing unit.]

But because taxes are somewhat stable—the level or volume, dependent on business gross profit income and household wage incomes, from which taxes are derived.

It will take massive imprudent spending and a deteroriation in overall gross income for government financing units to turn Ponzi.

Sum:

So, the different ways in which economic units  finance expenditure has been identified as Hedge Speculative and Ponzi.

The stability of the financial system/structure depends on the degree to which each of these financing modes are employed, the decision to use either of the financing postures (hedge, speculative or ponzi) depends on the expected and actual returns (income) and the cost of the debt incurred (interest rates.)

The more dependent on debt the economy is, the higher the debt/income ratio of the economic units. The higher the the debt/income ratio, the more the economy or individual units moves from Hedge to speculative and Ponzi.

[So, the Post-Keynesian think-tank isn't dismissive of the importance of real capital formation —emphasized by the Austrian Business Cycle Theory—in its advocating for interventionism, or appreciation of the significance of debt financing —public or private. Where it differs is in the choice of monetary system and the treatment of money]

 

The level and distribution of income and the validation of the Financial Structure:

Debts are validated when maturing commitments are fulfilled and expectations that future commitments will be fulfilled in maturity through the life of the debt contract. Debt financing organizations however operate on the expectations that a small percentage of debtors will not fulfill their commitments (loan loss provision if you will).

Since debt depends on various components of income sources, capital income for Non-financial corporations capital income must be large enough to enable maturing commitments to be satisfied. This can be either out of income, or out of new debt issued in rollover funding operations.

This access to roll-over funding depends on the anticipated future cashflows. The creditworthiness —or "emerging evidence on business profitability—must lead to an anticipation of sufficient future profit flows that'd enable refinancing.

For households and governments, wages and taxes need to meet similar standards if debt commitments are to be met and/or new debt negotiated.

He goes on to say that, "profits are critical in a capitalist economy because they are a cashflow which enables business to validate debt and because anticipated profits are the lure that induces current and future investment". Businesses issue debt based on these profit anticipation and lenders grant loans based on the same expectation.

So "any theory that aims to explain how investing in capitalist economy works must focus on determination of total profits and the division of total profits amongst debt servicing, household disposable income and retained earnings. 

Minsky dispute the Neo-Classical Synthesis theory that asserts that profits equal the marginal productivity of capital × the quantity of capital (ie the extra unit of output produced from employing a extra unit of capital and the actual quantity of capital.

This is because "fluctuations in employment, output and profits occur which cannot be explained by changes in the quantity or productivity of capital.

 

Answering the Question Why there hadn't been a Big Crisis as that of 1929:

The way the economy functions depends on the level, stability and prospects of profits. Profits are both the lure that motivates business activity and a flow that determines the accuracy of business decisions in the past

The question for profits has a side effect, in that investments leads to the acquisition of capital assets and these assets determine changes in the production process and overall output.

If the investment is apt then the improvements in technique (from capital assets development or acquisition) results in a larger 'yield', enough to offset costs and sustain profits. If the investment is not apt then the yield and flow of profit would be "attenuated" leading to a decrease in output, profits and investments.

But he also commented on the impact of 'big government' deficits on profits. Many an investment turn out to be profitable as a result of deficit spending the government undertakes, these huge deficits could override inept investments. The government then protects an inefficient industrial structure, and is usually accompanied by a rise in prices.

So "the current policy problem of inflation and declining rates of growth of labor productivity are not casually related but as a result of a common cause, the generation of profits by the means of government deficits. This happens where government deficits does not result from spending that leads to useful output.

So to the question "Why there hasn't been a crisis as big as 1929?" Is the answer that the size of the government has simply not made it possible. Enabling apt and inept business models thrive. Whenever unemployment increases the deficit explodes, making it impossible for profits to fall as they did in 1929-1933.

The government stabilises the real sector as  demander of goods and services, and stabilizes the financial sector by providing risk free and liquid liabilities when there is an aversion to private debt.

Minsky's analysis indicates that the price paid for avoidance of any serious depression is stagflation. The techniques to abort debt-deflation, also responsible for the "stepwise acceleration in the inflation rates".

Problems evident in the American economy since the mid-1969s are not due to the "vagaries of the budget deficits or errors in controlling money supply" but a reflection of the way the economy operates.

If the economy is to do better, a reform to the structure the economy so that instability from a heavily weighted financial structure is diminished, is necessary. 

It should be noted that Minsky's argument wasn't against government deficit but the mode of financing. Government spending (deficits) stabilises the economy at the expense of future stagflation —as markets move from hedge to speculative and Ponzi financing units.

But unlike Austrians, Minsky's point isn't that deficits are "bad" or monetary expansion which funds deficit spending is. The problem lies in the financial structure hence his advocation for a reform of the financial structure to limit the transition of economic units, moving from hedge to speculative and Ponzi financing units.

Chapter 3: The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to "Standard" Theory:

Professor Viner of Chicago wrote an extensive review on Keynes's General Theory (GT), this was the only review that drew a rebuttal by Keynes. Viner argued that the General Theory didn't make a "sharp break" from traditional economics. And Keynes's novel results were because velocity was allowed to vary and wages and prices assumed to be rigid.

The interpretation of Keynes's GT by Keynes is inconsistent with both Hicks-Hansen formulation of Keynesian theory and the neoclassical synthesis.

Differentiating between Keynes's and Hicks Theory and the Neo-Classical Synthesis 

Keynes’s General Theory broke from classical thought by emphasizing fundamental uncertainty, the non-neutrality of money, and the idea that investment drives income, not vice versa. He rejected Say’s Law and showed that involuntary unemployment could persist due to weak demand.

The Hicks-Hansen IS-LM model oversimplified this by assuming static equilibrium, fixed prices, and treating investment as driven solely by interest rates—ignoring Keynes’s focus on expectations and animal spirits.

The neoclassical synthesis further diluted GT by combining short-run Keynesian ideas with long-run classical assumptions, assuming the economy returns to full employment once prices and wages adjust.

Both frameworks distort Keynes’s vision. His GT was about dynamic uncertainty and persistent disequilibrium—ideas incompatible with the static models that followed.

Minsky's Financial Instability Hypothesis as a build up from Keynes's General Theory:

Misnky added that an accurate interpretation of Keynes's theory that is "consistent with Keynes's rebuttal to Viner,  leads to a theory of the capitalist economic process that is more relevant and useful for understanding our economy, then the standard neoclassical theory."

The theory which builds upon the interpretation of Keynes is the "Financial Instability Hypothesis". Minsky aimed to state this theory, and indicate why it is better suited to the economy than the dominant neoclassical synthesis. But before oroceeding he essays an argument to show how an interpretation of the GT "that rests upon Keynes' rebuttal to Viner leads to the financial instability hypothesis".

Interpretation of the General Theory in Light of Keynes's Rebuttal to Professor Viner:

Here a distinction is made from the standard/neoclassical theory and Keynes's General Theory propositions.

The standard theory and the neoclassical theory take both financial crises and output fluctuations as anomalies, offering no explanation. Keynes's General Theory "developed a theory of the capitalist process which was able to explain financial and output instability".

This it explained to be a result of market behavior in the face of uncertainty. How markets react to ever changing economic conditions and how they forge their expectations —which drive investment, output and employment—in the face of this uncertainty.

The new theory as a rebuttal to Viner is markedly different from "standard" interpretations. It "focuses on investment decisions within the context of capitalist financial practices as the key determinant of aggregate demand".

The main propositions of the General Theory centers around disequilibriating forces— in contrast to the Neoclassical synthesis which assumes full long-term equilibrium —that operate within the financial markets. This directly affect the valuation of capital assets (production goods if you will) with effects on the prices of current output.

Because money is needed to purchase capital assets needed for production, the allocation of these monies in the economy becomes the driving force behind investment activity, which determines output.

The price-ratio along with financial market conditions (liquidity and interest rates), determine investment activity, which has bearing on prices, output and employment.

The GT is concered with two types of prices — capital and financial assets on the one hand and current output and wages in the other. And how these prices are determined by different forces in the economy, and why such an economy is "so given to fluctuations".

The standard economic theory (or the neoclassical synthesis) start by examining exchanges in the goods and services market and proceeds to add production and capital assets, money and financial assets to its model.

This may lead to a coherent result but not an explanation of "periodic rupturing of coherence as an endogenous phenomenon". That is to say, it cannot explain output fluctuations as a result of market behavior.

 

Keynes View of Financial Rupturing:

Keynes' viewed financial rupturing of these coherence as originating from financial usages (of money), by way of investment activity. To explain this the  neoclassical "village fair" exchange paradigm has to be discarded and the definition of money as merely an exchange medium.

Keynes instead adopts a City or "Wall Street Paradigm". The economy viewed from the boardroom of financial institutions (a Wall Street Investment Bank).

Theorizing therefore begins with the assumption of a monetary economy with sophisticated financing. (A relevant scenario to the times and more so today). In such view, money becomes a "special type of bond that emerges as positions in capital assets are financed". This was first stated in his 1931 essay.

In the essay he stated that the owners of the multitude of real assets have financed these holdings by frequently borrowing money to acquire them.

To a considerable extent then, the owners of said assets have claims not in the real assets but in money. And a considerable part of this financing is done through the banking system. This is a view that holds them and today for this is a "specifically marked characteristic of the modern world".

To Keynes, we live in a world "in which changing view about the future are capable to influencing the quantity of employment". And the current variables most directly affected by these changing views about the future (expectations), are financial variables —market valuation of capital assets, prices of financial assets, and behaviors towards liability structures.

In Keynes' —and Post-Keynesian —theory, the time on referenced is calendar time and the future is always uncertain. Investment and financing decisions are made in the face of uncertainty. And views about the future can change within short periods of time. Changes in this views, affect the price of capital assets and financial instruments to which these assets refer to.

The financial system encompasses many more financial instruments than any concept f money includes. This contrasts with the classical and standard theory for in bother money does not affect the essential behavior of the economy.

The financial instability hypothesis is therefore amongst the number of interpretation of Keynes which is different from the standard interpretation of the GT. Minsky puts forward this hypothesis as an alternative to the standard neoclassical theory.

 

The Financial Instability View of our Economy:

The first few years post WWII were tranquil, with no "serious threat of a financial crisis or debt deflation process". But three threats of a financial crisis occured that required the Federal Reserve intervention in the financial markets to quell or abort potential crises.

The first threat was the credit crunch of 1966, were there was a run on banks certificate of deposits. The second was in 1970 and involved a focus on the run in commercial papers"following the failure of the Penn-Central Railroad." The third threat of a cross happened five years later which "involved a large number of over-extended financial positions, from speculative activities of big banks.

Minsky views the financial instability as a "recurrence of phenomena that regularly characterized our economy before world war II" and thus it becomes "reasonable to view financial crises as systemic, rather than accidental". Crises prone market behavior had reasserted itself in the workings of a capitalist economy.

He further notes that the decade after the world war 2 and before were different because of the Federal reserve interventions coupled with the income, output/employment effects that flow from the fiscal side of a larger government.

In other words, liquidity is being provided to the markets, and increased government spending offsets reduced private spending.

But the consequence to the above has been "accelerating inflation" which has followed each successful attempt at aborting financial crisis. Governments have had to trade off stability for price level increases in both financial assets and goods and services prices.

 

Validating Business Debt:

Since the viability of every financial instrument is based on the cashflow of the issuer/borrowing entity, the focus will be on business debt, as it is an essential character of the capitalist economy.

"The validation of business debt requires the prices and output be such that almost all firms earn large enough surpluses over labor and material costs to fulfill gross payments required by debt, or to induce refinancing".

That is the business must be a going-concern, with sufficient expected and earned future cashflows.

He goes on to point that gross profits of these businesses is dependent on "the expenditures on consumer goods by wage earners in consumption and investment goods production and by those who receive income from other than the production process."

Profit margins are dependent on mark-up pricing, but that of investment goods are determined in not as direct a manner as consumption goods are.  But for the former profit flow are aways determined by the relative scarcity of "specific capital assets" so, "present acceptable liability structures reflect current speculations in the course of future investment".

This means, debt financing will be forthcoming but dependent on the expectations of future returns from investments.

Gross profits are used to validate debt and finance control of business entities. The gross profits after tax and debt repayments becomes the cashflow that is accrued to shareholders. And equity share prices become the result of capitalizing these expected cashflows.

Share prices fluctuate in the market based on market valuation of the company's capital assets. The market value of investment goods determine its price and which in combination with supply (of these investment goods) conditions of the financial markets (how liquid the market is), determining investment.

When you include government purchases of goods and services, gross profits will also depend on government deficits, in addition to the production of consumer and investment goods.

This profit implication of big government can "offset a tendency for the debt-sustaining capacity of business to diminish whenever financial market disturbances induce a decline in consumer and business spending."

Hence the earlier point of government being a stabilizing force preventing recessions from being as severe as 1929.

"In a world with capitalist financial usages, uncertainty —in the sense of Keynes— is a major determinant of the path of income and employment. As validation of debt positions depends on the future expected cashflow of the entity.

 

Analyzing Debt Income Relations:

The natural starting place for analyzing debt and income relations, Minsky took an economy with a cyclical past which is just now doing well. The inherited debts reflect the economic history were there was a decline in income and growth. Liability structures are accepted with a margin of safety soon that expected cashflows will cover debt obligations.

As the economy continues to grow and business boom, debts become easily validated and companies heavily levered flourish. Then the margin of safety seems to high and is adjusted making debt more accessible. Debt financing increases.

This increase in debt financing raises the price of capital assets. Stable growth becomes inconsistent with the anner in which investment is determined in such a economy which debt financed capital ownership.

The Basic Instability In a Capitalist Economy:

It then follows that the tendency to move from fairly hedged to speculative financing posture is the basic Instability in a capitalist economy. An increased access to finance eventually bids up asset prices relative to current output prices.

The money of standard theory he says, doesn't capture the monetary phenomena relevant to the behavior of the economy.

During a period of successful functioning of the economy, private debts and speculative fiance are validated. However speculative units must continually refinance their debts. This leaves them opposed to higher interest rates. As opposed to hedge financing money supply increases are invalid in an economy with a higher proportion of speculative units.