Financial instability hypothesis

The "financial instability hypothesis" is the term given by the American economist Hyman P. Minsky to his theory explaining why capitalist market economies are prone to instability. The theory integrates macroeconomic analysis with an original microeco- nomic view of how capitalist firms operate. Financial fragility refers to the build-up of debt that precedes the breakdown in economic activity, in a market capitalist economy with a sophisticated debt-based financial system. The crisis then bequeaths a legacy of unsustainable debt to succeeding periods until a boom revives expenditure and sales revenue sufficiently to make the debt burden manageable, whereupon the cyclical build- up of debt resumes.

The macroeconomic part of the analysis is essentially a business cycle theory in which booms and slumps are driven by business investment in fixed capital. Rising investment causes an increase in general economic activity and sales revenue. Falling investment causes a decline in business activity in general, and a fall in sales revenue. This part of Minsky's analysis was drawn from the work of John Maynard Keynes and his General Theory (1936). However, Minsky considered that as investment rose it would become financed by borrowing. The rising debt levels would need to be serviced out of sales revenue, so that if investment, and the resulting sales revenue, fell off, businesses would succumb to a debt crisis. The crisis is then a prelude to economic recession, possibly even a prolonged depression (Minsky was always conscious in his analysis of the possible recurrence of the 1930s depression through which he had lived in the second decade of his life).

The microeconomic part of the analysis is a highly original approach to economic decision-making in which economic agents (households, banks and firms) make decisions on the basis not just of income and expenditure, as postulated in conventional microeco- nomic analysis, but also on their balance sheets. Minsky recognized that, with credit, it is possible to generate cash flow not only from selling commodities, but also from selling assets or entering into debt contracts. A balance sheet therefore represented for Minsky a set of dated financial commitments (liabilities) or claims (assets). The survival of firms therefore depends on the liquidity of those claims and credit availability, as well as the flows of income from which to service those financial commitments.

The liabilities side of a balance sheet was what Minsky called a financing structure. It could be a "hedge" financing structure, if the income derived from the assets covered financial commitments at all times; or it could be a "speculative" financing structure, if income at times fell short of commitments, but overall covered those commitments; or it could be a "Ponzi" financing structure, if income overall would not cover commitments, so that the firm would end up with expanding liabilities relative to assets. Financial fragil- ity was marked by "deteriorating" financing structures, with "hedge" financing becoming "speculative" finance, and "speculative" financing becoming "Ponzi" finance (Minsky, 1982; Minsky, 1986, ch. 9 and appendix A).

For Minsky, business investment was always speculative, unless it was wholly financed from firms' reserves or internal finance. But investment is crucial because it generates sales revenue and in this way circulates the liquidity in balance sheets around other balance sheets in the economy. The balance sheets in the economy set a threshold which business investment must achieve to secure expected payments on debt liabilities. When investment falls below this threshold, balance sheets deteriorate as a prelude to financial crisis.

The financial instability hypothesis therefore explains how a financial crisis breaks out because of inadequate business investment, rather than because of interdependent balance sheets (economic units whose assets are the liabilities of other economic units), or because of falling asset prices, as some commentators have suggested (see Toporowski, 2005, ch. 14; Kregel, 2012).

In practice, there are three complications that suggest inconsistencies in Minsky's analysis. The first is the issue of equity finance. This, in Minsky's view, is a classic form of "hedge" finance, because financial commitments are contingent upon adequate operating profits. Recent economic booms in the United States and in Britain have been marked by shifts towards equity financing, and hence a more stable and sustainable form of finance. Yet financial crises broke out at the end of the 1990s and after 2008. A second complication is the existence of deposits that are the counterpart of borrow- ing to finance investment. These deposits must appear somewhere and would normally emerge as the profits of firms in the economy. Debt-financed investment may therefore provide its own "hedge" (although not necessarily for the firms incurring the debt). Finally, there is the matter of smaller enterprises that do not have access to, or simply do not make use of, sophisticated financing. Such firms may not be very significant as business investors. They are important, however, for output and employment in most countries.

Despite these gaps and inconsistencies, the financial instability hypothesis remains the most complex attempt to model business cycles in capitalist economies using sophisti- cated credit. In its conclusions about the nature of finance and its operations, the theory is not so much a "hypothesis" as a penetrating critique of the way in which free markets in banking and finance work, whose insights have not been equalled by Minsky's critics (most notably in Kindleberger and Laffargue, 1982).

See also:

Asset price inflation; Debt deflation; Financial crisis; Financial instability; Macro- prudential policies; Minsky, Hyman Philip.