Thursday, July 16, 2009

'The Financial Instability Hypothesis' of Hyman Minsky

The simplicity of the arguments presented by Hyman Minsky in this 1992 paper are truly beautiful to behold. In it, he looks to unravel the mysteries of how our modern capitalist economy cycles from boom to bust and back again. In doing so he neatly captures how our thirst for more is at the heart of the industrial complex.

Download it in its old-world typewriter-smitten glory here. But for those that want the poorer, glue-sniffing cousin’s version…read on

Minsky starts on the basis that capitalism is driven by a societal desire to accumulate money over time – he calls it ‘capital development in the economy’. To achieve this goal, some of us are prepared to part with our ‘present money’ and exchange it for ‘future money’.

“The present money pays for the resources that go into the production of investment output, whereas future money is the ‘profits’…”

So in our capitalist system, we can seek to grow money by buying production with our ‘present money’ with the hope that the things we then own will give us back more ‘future money’.

Helpfully, we don’t even have to use only our own money to buy into the capitalist dream. As Keynes put it…

“There is a multitude of real assets in the world which constitutes our capital wealth – buildings, stocks of commodities, goods in the course of manufacture and of transport, and so forth. The nominal owners of these assets, however, have not infrequently borrowed money in order to become possessed of them.”

Its our banking system that facilitates the financing process – interposing a ‘veil of money’, where banks take depositors funds and, after the necessary due diligence, lend them to the new owners. “Institutional complexity may result in several layers of intermediation” but ultimately this process promotes the capitalist system to (hopefully) grow through time.

And ‘through time’ is the point, as Minsky says:

“Thus, in a capitalist economy the past, the present, and the future are linked not only by capital assets and labor force characteristics but also by financial relations.”

Inescapably, then, our debt supported system becomes prone to the whims and fancies of humanity. The process whereby ‘money is lent to owners on the basis of expectations about future profits’ is necessarily a subjective one. Thus:

“Expectations in relation to ‘profits’ determine both the volume of financing and its market price. Conversely, actual ‘profits’ that are realised determine whether these financing commitments are fulfilled.”

So when expectations of profits are running high, more money is available for borrowing and at cheaper rates. If the reality of profits falls short of expectations then, well, someone loses some of their ‘future’ money.

“The financial instability hypothesis, therefore, is a theory of the impact of debt on system behaviour and also incorporates the manner in which debt is validated.”

With this framework set out, Minsky goes on to identify three types of financing:

1) Hedge financing – where cashflows from operations are sufficient to cover all repayment commitments

2) Speculative financing – where cashflow from operations are sufficient to pay interest but little else

3) Ponzi financing – where cashflows from operations can just about cover the Christmas party expenses but fall short of being able to pay either interest or repay principal.

No prizes for guessing which we have recently been witness to.

With these types of financing in mind, he then posits two theorems (dammit, gotta get me some of those theorems):

Theorem 1: An economy has financing regimes under which it is stable, and financing regimes in which it is unstable.

Theorem 2: Over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.

So, for Minsky the current malaise we are struggling through was a product of our own hubris. Through an over-abundance of good times, our expectations for the future money from profits simply outstripped our real profit potential. As our expectations stepped up, we were forced to push the blinkers ever closer together to avoid noticing the sizable shortfall that was accruing between our expectations and reality. In the half-light, where let’s face it we all look better, the Ponzi schemers could buy the drinks (while emptying our pockets).

So what does all this mean for us here and now? Well, a couple of things.

1) The great unwind – not sure we have made it to home-base yet. If we accept the definition of a ‘hedge financing’ and its implications for a stable system, it’d be fair to say that while we have come a long way, the global finance system doesn’t appear to be self-sustaining yet. Indicators to look at are home loan defaults in the US, commercial property valuations versus debt covenants (the global CMBS seraglio), and banks capital adequacy in Europe.

2) Perhaps more interestingly, are Minsky’s comments on the rising role of governments and how that impacts his model.

“…much greater participation of national governments in assuring that finance does not degenerate as in the 1929-1933 period means that the down side vulnerability of aggregate profit flows has diminished. However, the same interventions may well induce a greater degree of upside (ie. inflationary) bias to the economy.”

Compelling stuff (well at least to my vapour intoxicated synapses). My take on this? The government stepping up may soften the blow but can only prolong the pain. Inflation is the longer run reward.

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