A Review of Hyman Minsky's Financial Instability Hypothesis 'Can It Happen Again' [Part IV]

- By Chinedu Okoye 

Chapter 6 Financial Instability Revisited: The Economics of Disaster.

Here the repeated occurrences of financial crises is discussed and analysed in detail. He looked to answer the questions whether; the fundamental changes in the US economic system can prevent another great depression or whether "our knowledge and power is still inadequate as that crises and deep depressions are still possible."

Minsky argues here that, "fundamentals are unchanged" and "sustained economic growth, business cycle booms, and the accompanying financial developments still generate conditions conducive to disasters for the entire economic system."

He follows that every disaster is accompanied by a combination of three things; an initial displacement or shocks, structural characteristics of the system, and human error.

His theory argues that "the structural characteristics of the financial system change during periods of prolonged expansion" banks and Financial institutions take on more risk to meet businesses demand in the hopes of profits. "These changes cumulate to decrease the domain of stability of the system".

After an expansion, an event that is not of unusual size or duration can trigger sharp financial market reactions. Displacement or human errors may be the cause.

Thus, there is a "special type of uncertainty is inherent in an enterprise system with decentralized decisions and private ownership of productive resources." And the financial system distributes this uncertainty, he says.

And as a result a model that recognizes problems involved in decision making in the face of the intrinsic fact of uncertainty is needed to understand and explain financial instability.

Reinterpreting Keynesian Economics:

A "reinterpretation of Keynesian Economics" as a model of how monetary constraints works are needed before the stability properties of the economy can be examined. As there is a tendency for a capitalist economy to "explode" into a boom or euphoric state.

He examined the updated information of the type of data analysis in earlier studies, explored additional bodies of data, and generated new data, as "only with information can the problem be made precise and the propositions tested."

The institutions and usages in finance ",due to both legislation and financial practices" are much different from what they were prior to the great depression (Minsky writes as at the time of this publication).

It is necessary, he says, to "gauge the power of deposit insurance in order to estimate the conditions under which a crisis can develop." This means the smoothening operations that go into data generation as well as econometric analysis will tend to minimize the importance of crises".

Because of these new technologies, he says it might be that "the most meaningful way to test propositions as to the cause and effect of financial instability will be through simulation studies". As they can be used to detect the various ways that financial instability can be induced.

The Economics of euphoria:

The mid 1960s experienced a change of state. Political leaders and economists were of the idea that the was a New era "characterized by the end of the business cycle".

Cycles were to be characterized by successive periods of growth, and the US entered the state of "fine-tuning". This doctrine "asserted that even recessions in the rate of growth of income could be avoided.". However the substance of this change was an investment boom.

This boom saw the rate of coporate investment increase in each year from 1963 to 1966, "investment was guided by the believe that the future promised perpetual expansion". An economy ruled by such expectations as the US in the 60's is what he defined as "euphoric".

If the expectations of a normal business cycle —of booms and busts—was replaced by that of steady growth. Then two immediate consequences follow. (i). the gross profits that had reflected expected recessions —i.e., the bust after the boom—is replaced by expectations of steady growth; (ii). with the belief that growth will be unending, the expected down time for plant and equipment decreases which then raises their present values.

The confident expectation of a steady income stream increases the appeal of portfolio investments. This then translates to a shortage of financial resources as the expectations increase demand for financing.

"Those that supply financial resources live in the same expectational climate as those that demand them". This change in expectations make demanders with liability structures that previously would have been viewed as ineligible by the suppliers of capital become acceptable.

He says, "such an expansionary new era is destabilizing in three senses. (i) it raises the value of exisiing capital; (ii) an increase in the willingness to finance capital acquisition that would have been previously considered as high cost liabilities, and (iii) the acceptance by lenders of assets that would previous considered low yield. (i and ii represent an increase in borrowers and lenders risk respectively).

Financial Institutions as both Demanders and Suppliers of Capital:

Minsky points that Financial Institutions are "simultaneously demanders in one and suppliers in another set of financial markets." Once euphoria sets in, they accept liability structures of borrowers they would not have accepted in "a sober expectational climate".

Money and Treasury bills become expensive to hold (ie have a high opportunity cost), in relation to riskier higher yielding assets —say corporate bonds. The euphoria leads to these financial institutions "engaging in liquidity-decreasing portfolio transformations" this is accompanied or led by the initial investment boom.

Pressure on Particular Segments of the Financial Markets in a Euphoric State:

Money market interest rates rises as a result of increased demand for investments, and the elasticity of demand (for money) reduces.

When this euphoria occurs short-run money supply can be increased to meet investment demand independently of monetary policy. But "to the extent that such assets [loans issued by banks] are long lived and held by deposits institutions with short-term demand liabilities, pressures upon deposit institutions will accompany the euphoric state of the economy."

Since this institutions must meet interest rate competition, interest rates can only go up, as they must rise relative to what they pay depositors.

This rise in interest rates places immense pressures on deposit collecting financial institutions (savings and loans companies, mutual savings banks).

The rise in the value of real capital assets increases in this state of expectations and this reflected in the stock prices of a company. Increased debt financing of these assets can also raise expected returns in equities. Portfolio allocation shifts towards equties as a result, (flowing from deposit collecting institutions), as the expectations of a recession diminishes. And the stock market boom then feeds upon the investment boom.

All in all, the euphoric boom has a short lifespan"

"As rates rise equity prices fall as the opportunity cost of holding them rises. Then a hedging of portfolios and reconsideration of investment programs takes place ". This reconsideration and the lagged effects on other sectors leads to an increase in costs combined to yield a shortfall in incomes.

"The result is a combination of cashflow commitments inherited from a burst of euphoria and cashflows receipts based upon lower-than-expected income." Investment demand decreases from its euphoric levels.

Cash Flows:

Financial crises, he says, occurs "because units need or desire more cash than is available from their usual sources". They then "resort to unusual ways to raise cash"

Minsky examines various types of cash Flows, the relationship among them and with other characteristics, in this section.

The "varying reliability of sources of cash flow is a well-known phenomenon in banking theory". A source of cash is reliable when there is no "net market demand" for cash, (ie deposits lag withdrawals), and unreliable when there is such "net demand" upon the source. (Source could be banks, loans and savings companies mutuitla funds etc).

Under pressure these various financial and nonfinancial institutions may withdraw by necessity or as a defensive policy from financial markets. This forces units to look forward for new "financing connections".

Going further he points that; for most consumers, and nonfinancial businesses, the largest source of cash is from their income/profits from labor or sale of output.

The financial assets and liabilities of an economic units can be transformed into time series of contractual cash payments and receipts. The various items in the contractual receipts and payments depend upon national income." And just as well "the fulfilling mortgage contracts depends in consumer disposable income.

So "estimates of direct and indirect impacts of variations in national income upon the ability of units in the various sectors to meet their financial commitments can be derived." As each unit has its reserve and/or emergency sources of cash, stored mostly in marketable or redeemable assets.

Typically savings bonds, and time deposits are go-to for consumers to store their reserves. They could also store it as idle cash balances, as cash has a special birtue of being available when needed, absent the functionality of the market.

The largest number of units use their income receipts to meet financial commitments (mortgages, credit card debt, etc.)

The typical financial unit acquires cash to meet its payment obligations, stated as liabilities, this is not from any cash flow from its assets or from selling assets, but by "emitting substitute liabilities".

When a unit is forced to refinance it's debt position instead of drawing from its income cashflows, additional pressures are placed on financial institutions.

 

Empirical Generalizations;

So whilst some financial relations are based on periodic liquidation of its positions,.capital market dealers, liquidate position in one asset to acquire a new asset. But, if organizations that normally use cash from its income to settle their positions (debt), decides to sell it, the market for financial assets becomes thin.

The prices of these financial assets experience a drop as a result. He gave an example that if all home owners were to put their homes in the market up for sale, the housing market might not be able to handle such supply without "significant price concessions". These concessions translate to decline in networth for all units holding the asset.

Making an empirical generalization, Minsky states that "almost all financial commitments are met from two normal sources of cash: income flows and refinancing of positions." Units that have real capital goods as assets cannot sell out their positions, for others they can refinance through an unusual source.

Furthermore, asset prices can fall much more rapidly than income prices. Any increased desire to acquire cash by sale of positions in financial assets will only result in large-scale decreases in Networh.

But not all assets are allowed to fall in price, and then prices of some assets would be stabilized by the Central Bank. Through purchases of these securities o loans.

When a large number of units resort to extraordinary source of cash. These conditions trigger financial instability.

Thus; "The adequacy of Cash flows from income relative to debt m, the adequacy off refinancing possibilities relative to position, and the ratio of protected to unprotected financial assets are determinants of the stability of financial system. "

Financial Instability and Asset Prices/Valuation:

 

Keynesian Economics and Uncertainty:

"The essential difference between Keynesian and both classical and neoclassical economics is the importance attached to uncertainty." The Keynesian proposition with respect to money, investments and employment can be understood only, as a statement of a systemic behavior is a world of uncertainty.

In this uncertain world, a "defense against some possible highly undesirable consequence of some possible states of the world is to make appropriate defensive portfolio choices."

Making precise his view of uncertainty, Keynes asserted that "in a world without uncertainty, no one, outside a lunatic asylum, would use money as a store of wealth". Thus, people hold money and Treasury bills in an attempt to behave in a rational manner in an unpredictable universe.

Portfolio Decision Making Under Uncertainty:

A significant amount of wealth holders try to arrange their portfolios so that they are "reasonably well protected". In making portfolio choices, economic agents are guided by "extrapolation of current situation or trends, even though they may have doubts about its reliability".

This underlying lack of confidence and expectations make the present values of future incomes unstable. An unusual event can lead to a revaluation of assets. And expectations not only for the financial markets, but for the future of economy at large.

The process of setting a value on an asset can be separated in two stages;

First, "the subjective beliefs about the likelihood of alternative states of the economy, and second the degree of belief attached to the various alternatives states of the economy."

The assets available are referred to as inside and outside assets. Outside assets consist of government debt and money. The nominal value of these asset (money and government debt) are dependent on the state of the economy.

Two types of period are assumed here, one in which beliefs are held with confidence about the alternative states of the the economy within time horizons, and another where bets are placed under duress or hgher uncertainty with "markedly lower relative values attached to assets whose value depend on the overall performance of the economy.

These periods (of high uncertainty) would see portfolio allocation shifts towards assets that offer protection against declines in nominal values. The premium of assets that permit flexibility will be higher in such periods.

The Liquidity Preference Theory:

The Keynesian liquidity preference theory he says, "encompasses both confidence conditions". And expectations of the likelihood of different states may be held with varying degrees of confidence. Where expectations are stable "portfolios are managed so that the outcome will be tolerable regardless of which states of nature rules.

Most units tend to weigh heavily the avoidance of disasters, such as a liquidity crisis." And assets that "offer protection against a liquidity crisis or temporarily disorganized markets would be part of a rational portfolio under all circumstances."

He adds that "a preferred market may exist for assets that obviate against capital losses." So liquidity preference can be defined as a rational person's demand for money as an asset". This lead to "a determinate demand for money for any value of higher-order uncertainty."

So, any increase in uncertainty can shift the liquidity preference function. But this change in uncertainty can happen in reverse.  An increase in uncertainty will see relative prices of inside assets (real capital and equities) fall relative to the price of outside assets. Likewise, a decrease in uncertainty would make prices of inside assets increase relative to prices of inside assets.

"In a decentralized private-enterprise economy with private commercial banks, we cannot expect the money supply to increase sufficiently to offset the effects of a sharp increase in uncertainty upon inside assets."

We can also not expect the money supply to fall sufficiently to offset a sharp decrease in uncertainty. Profit maximizing lenders would "behave perversely" in that a decrease in uncertainty is met with an increase in money supply and an increased uncertainty met with a contraction in money supply.

Uncertainty and Asset Prices:

Paraphrasing Keynes he say, that in a free from uncertainty no one will hold Treasury Bills as a store of wealth except their returns equal that'd of real assets (inside assets).

In a euphoric economy it is thought that, "past doubts about the future of the economy were based upon error". The behavior money and capital market interest rates in such a period is consistent with a rapid convergence of the yield on default free and default possible assets.

This convergence sees interest rates on default free assets (Treasury bills), rise —their prices falling relative to default possible assets (So yields on default free assets rise as does the price of default possible assets. There are also other assets in addition to these two categories that carry some degree of protection; savings deposits and corporate bonds.

Banks also carry partially protected assets and a rise in Intermediation (increases in bank money creation), may unbalance portfolios to favor default-free assets and the stability of banking through creation of money in hopes of stimulating the economy rests on the belief that banks and monetary authorities are able to give some level of protection to their liabilities.

In summary;

The above argues that;

• The relative prices of assets are affected by portfolio imbalances that flow from changing expectations and views of uncertainty concerning future states of the economy.

• A decrease in uncertainty will raise the price of units in the stock of real capital or inside assets for any given supply of money, outside assets, and assets that are partially protected against adverse economic behavior.

• An increase in uncertainty will lower the prices of inside assets.

• For a given state of uncertainty and stock of real capital assets, the greater the quantity of money, other outside assets and protected assets, the greater the price of of the stock of real capital.