Source: Qile Club
Introduction:
We first encountered the name Hyman Minsky over a decade ago in Jeremy Grantham's GMO Capital Management annual report. In his book, Stabilizing an Unstable Economy, Minsky reinterpreted the neglected financial instability factors in Keynesian theory and proposed the Financial Instability Hypothesis. Minsky's most important argument is that 'stability contains instability.' When strong and stable economic growth seems to have been achieved, it already harbors the seeds of economic collapse. Even maximal stability includes instability brought by investments, which yield returns but are also highly risky. Once a financial crisis erupts, it forms a 'Minsky Moment' or 'Minsky Crisis.'
Stability contains instability.
The fundamental principles of Minsky's financial instability theory are derived from John Maynard Keynes's General Theory of Employment, Interest, and Money (commonly referred to as The General Theory), Irving Fisher's description of debt deflation, and the works of Simon Kuznets.
Economists who experienced the 1930s did not overlook financial collapse or prior speculative behavior when explaining economic phenomena at the time. Keynes’s investment theory and financing theory for investment were subsequently ignored in traditional Keynesian theories.
Since financing for investment is a significant source of instability in the economy, it becomes the subject of analysis to shift the economy from instability toward stability.
Minsky rejected the equilibrium methodology of mainstream economics, which is disconnected from the real world. Instead, he proposed the concept of 'calm periods,' characterized by a robust financial system and a lack of financial innovation.
When the market system appears to be stable, the functioning market forces can drive the market toward instability. Therefore, even if equilibrium is seemingly achieved, it will trigger changes in market behavior, quickly steering the economy away from equilibrium.
Minsky emphasized the volatility of investment, arguing that fluctuations in cash flow generated by investment significantly impact corporate balance sheets. He recognized that all mathematical statistical models cannot accurately explain crucial structural changes and shifts in behavioral patterns in the economy and finance.
The essence of Minsky's Financial Instability Hypothesis lies in understanding the self-reinforcing power of speculative financing. He focused on explaining why the optimistic employment, investment, and profit growth desired by entrepreneurs and bankers ultimately lead to economic volatility and unacceptable outcomes.
There are many explanations for the causes of financial crises, but elucidating the nature of financial crises at their root and clarifying the mechanism through which the financial system influences business cycles is extremely challenging.
Minsky, with his unique insight, applied the Financial Instability Hypothesis to provide a highly explanatory analysis of economic crises. Since the outbreak of the 2008 financial crisis, his ideas have gradually been accepted by an increasing number of people, leading to the term 'Minsky Moment' being used to describe financial crises characterized by the collapse of asset prices.
Minsky observed as early as the late 1960s that economic instability had become exceptionally pronounced, unlike the two decades following World War II. The underlying cause of this instability lies in speculative financing. Entrepreneurs and bankers transformed what was initially a potentially dynamic financial system into a fragile one, eventually turning instability into reality. Periods of stability in capitalist economies are only temporary.
The manner in which speculative booms occur, and the way an unstable, crisis-prone financial and economic system develops, is critically important for any description of the economic operational process.
Instability arising during a period of relatively stable growth can evolve into speculative prosperity. This occurs because, as a reaction to successful economic performance, both commercial firms and financial organizations alter their acceptable and anticipated debt structures.
In analyzing instability, speculative panic, debt deflation, deep recessions following speculative booms, and subsequent economic recoveries are less significant than the fragility and instability of financial institutions during periods of sustained stable growth.
Instability does not stem from external fluctuations but is caused by intrinsic economic processes. Capitalist economies with complex, developed, and continuously evolving financial systems are prone to fostering conditions that lead to imbalances, such as runaway inflation and severe depressions. Instability increases uncertainty.
In terms of uncertainty itself, or from the perspective of the natural development of the economy, increasing uncertainty acts as a constraint on economic behavior. However, more importantly, within a capitalist environment, the destructive effects of instability are amplified. In an unstable economy, speculation dominates business operations.
Basic Propositions of the Instability Hypothesis
Keynes's seminal work, 'The General Theory,' was published in 1936. Its core focus was the analysis of investment issues under conditions of uncertainty and capital adequacy in a financial context. However, later economists interpreting 'The General Theory' overlooked this aspect of Keynes’s work.
A key perspective emerging from this issue is that the economy is always in a temporary state because it accumulates instability in response to endogenous forces of disequilibrium. Thus, instability represents an inherent and unavoidable flaw of capitalism.
The primary defect of the neoclassical synthesis theory lies in its failure to explain how the economy falls into an equilibrium trap.
Since neoclassical theory does not account for inherent destabilizing forces and lacks a historical perspective, within its theoretical framework, economic fluctuations, disequilibrium, and financial disorder are deemed to occur only under external shocks. Consequently, numerous historical events can be interpreted as the result of institutional failures during specific periods.
A typical example is that the Great Depression of the 1930s cannot be explained by the systematic characteristics of neoclassical theory.
The economy we operate in is a capitalist economy characterized by continuous investment. The output of past investments must be justified by the income obtained by the owners of capital assets. For a well-functioning capitalist system, prices must include profits.
The core question in understanding how the economy operates is 'what determines profits.' In a capitalist economy, profit-driven enterprises generate returns that make past investments profitable while inducing future investments. Evidence shows that today’s profits depend on today’s investments. Investment is the most significant determinant of profits, though not the only one.
Once the determinants of investment are clarified, a comprehensive explanation of financial instability theory can be provided. Investment is the most essential determinant of a capitalist economy's operation. The cyclical characteristics of a capitalist economy depend on the relationship between profits, capital asset prices, financial market conditions, and investment.
Economic stability depends on the manner of investment and the financing of capital asset positions. Instability arises from internal rather than external mechanisms of the system. The economy is unstable not because it has been subjected to unexpected shocks such as oil, war, or currency but due to its intrinsic nature.
The hypothesis of financial instability rests on two fundamental propositions: ① A capitalist market economy cannot generate sustained equilibrium; ② Severe business cycles stem from the intrinsic characteristics of finance, which are critical to capitalism.
These two propositions stand in stark contrast to the neoclassical synthesis theory. The perspective of financial instability places significant emphasis on the methods of financing the ownership or control of capital assets, a factor largely overlooked by mainstream theories.
Furthermore, the theory of financial instability identifies the factors that have genuinely changed during the process of institutional evolution and explains that although business cycles and financial crises remain constant features of a capitalist economy, the actual trajectory of an economy’s operation still depends on institutions, conventions, and policies.
The prices of capital and financial assets depend on the expected cash flows they generate and the capitalization rate. Each investment includes specific risks and uncertainties.
The normal functioning of a modern capitalist economy depends on whether capital income, and thus investment, can reach and maintain a certain level at which capital assets can earn sufficient income to repay past debts. If this level is not reached, the prices of capital assets and claims will decline, negatively impacting investment demand.
A defining characteristic of a capitalist economy is the existence of two sets of price systems: one for current output and another for capital assets. The prices of current output and capital assets are determined by different variables and in different markets.
The technical characteristics of capital assets lead to the fundamental relationship in the economy of 'using today's money to make tomorrow’s money,' but the complex financial system amplifies this relationship in terms of scale, scope, and intensity. Therefore, success or failure hinges on the same factors. The financial structure is both the reason for the adaptability of a capitalist economy and the source of its instability.
In each specific short-term scenario, there exist forces within the economy that compel various factors to change; these are the 'disequilibrium forces.' These disequilibrium forces may sometimes be weak, but they continuously accumulate strength to the point where, after some time, they become powerful enough to disrupt any equilibrium. The so-called 'equilibrium' refers to a period during which no rapid, destructive changes occur, i.e., a 'calm period.'
Certainty contains uncertainty.
The Financial Instability Hypothesis encompasses both stability containing instability and certainty containing uncertainty.
From Minsky's perspective, uncertainty refers to situations where the outcomes of certain events cannot be inferred from general patterns of the past. Uncertainty in economics is unrelated to risks that can be mitigated through insurance or risks akin to gambling.
To a large extent, uncertainty exists because the future is difficult to predict. In a world with uncertainty, seasoned investors respond to unforeseen events based on their experience from past decisions.
In corporate capitalism economies with stock trading markets, the market value of a company's capital assets and market position replaces the price of capital assets. This value changes as the stock market moves through different phases.
A prosperous stock market leads to an increase in the potential market value of capital assets in the economy; conversely, a sluggish stock market reduces their potential market value. In a bull market, the rise in the trading value of stocks makes anticipated price increases a decisive factor for both borrowers and lenders in determining the required margin of safety.
Conversely, a decline in stock prices in the stock market will reduce the borrowing capacity of stockholders and increase their debt burden. Therefore, investment is a financial phenomenon. A prominent feature of the economy is the existence of complex lending relationships based on various margins of safety. In any economy where financial markets are part of the investment decision-making mechanism, there will be some powerful internal instability factors.
Minsky divided cash flows into three basic types: income cash flow, balance sheet cash flow, and portfolio cash flow.
The first two are easy to understand. Portfolio cash flow refers to the result of decisions to purchase or sell assets or to incur new liabilities.
The relative weight of these three types of cash flows determines the financial system's resilience to financial collapse. An economy that primarily uses income cash flow to fulfill debt obligations has relatively strong immunity to financial crises: it possesses financial robustness.
An economy that extensively uses portfolio cash flow to repay debts on the balance sheet is more prone to financial crises: it exhibits at least potential financial fragility.
From Wall Street's perspective, capital assets have value not because they produce tangible products, but because they generate profits. The technical capabilities of the Boeing 747 are secondary in importance; what matters is its ability to make the production of the 747 aircraft profitable under specific market and economic conditions.
Similarly, from Wall Street’s point of view, whether a nuclear power plant produces electricity, damages the environment, or is safe does not matter; what is important is the calculation of expected costs and revenues.
In the economy, the future profitability of the capital assets controlled by a company plays a crucial role in investment decisions, as it determines whether financing should be sought for production and ownership of capital assets.
If a capital asset cannot generate sufficient revenue for its current and future owners, it holds no value. The cost of newly produced capital assets — the price of investment goods — is a significant factor influencing economic trends.
Purchasers of investment goods believe that they can generate profits — the value of stock capital assets is also based on this logic. If the expected income is capitalized and results in a capital asset value higher than the price of the investment good, then the investment good, as a capital asset providing assurance for production, is anticipated to yield sufficient profits.
Highly disruptive forces
Minsky argued that three types of capital position financing can be identified within the economic financing structure: hedge financing, speculative financing, and Ponzi financing.
Ponzi financing is often associated with marginal or fraudulent financing activities, although its initial intent is not necessarily fraudulent. A Ponzi-financed entity is not only vulnerable to factors impacting speculative entities but also experiences deterioration in its balance sheet due to the growing interest or dividends paid on increasing debt.
Thus, the cash flow required to meet financing commitments increases, further worsening the equity-to-debt ratio within the capital asset balance sheet.
The weighting of hedge financing, speculative financing, and Ponzi financing is a decisive factor in economic stability. The presence of substantial speculative and Ponzi-financed positions constitutes a necessary condition for the outbreak of financial instability.
The robustness or fragility of the financial system depends on the size and strength of the margin of safety, as well as the likelihood of early financial turbulence deteriorating. When speculative entities and Ponzi-financed entities must continuously finance their positions, they become highly vulnerable to financial market instability.
The greater the share of speculative financing and Ponzi financing, the lower the overall margin of safety in the economy, and the more severe the vulnerability of the financing structure.
Empirical evidence shows that the economy oscillates between robust and fragile financing structures, and the prerequisite for a financial crisis is the existence of financing structure instability prior to the crisis. Economic success leads people to overlook the possibility of failure, inflating optimistic expectations about future economic performance. Short-term financing for long-term investments becomes increasingly common, becoming a norm within the economy.
In a world characterized by uncertainty, factors such as the prolonged production periods of capital assets, private ownership, and complex Wall Street financing activities cause an originally robust financing structure — within which the economy operates smoothly — to become increasingly fragile over time.
Endogenous forces make the environment dominated by hedging finance unstable, and as the proportion of speculative finance and Ponzi finance increases, the forces causing economic instability will grow stronger. As investment booms driven by external financing emerge, economic vulnerability will increase significantly.
Financing relationships create an environment where investment booms lead to a rise in speculative finance, which in turn makes the economy more prone to crises.
Therefore, economic instability stems from capitalist financing. Any temporary economic stability will transition into economic expansion, with increased reliance on external financing for speculative investments. When successful economic performance leads investors to believe that previous or even current safety margins are too high, these safety margins will gradually erode.
In summary, capitalist financing will ultimately evolve into a highly destructive force within the economy. Both economies and companies inherently carry the risk of instability within stability and uncertainty within certainty.
Howard Marks said that giving up the illusion of certainty can keep you out of trouble. Similarly, giving up the pursuit of stability can also keep you out of trouble.
Editor/Jayden