Hyman Minsky’s Financial Instability Hypothesis

In a 1992 working paper for the Levy Economics Institute, economist Hyman Minsky expounded his financial instability hypothesis.
Minsky begins by noting that incidents of inflationary and deflationary spirals have historically occurred.
These historical episodes, Minsky writes, are inconsistent with the view of Adam Smith and Leon Walras that capitalist economies are fundamentally equilibrium seeking.

[F]rom time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes the economic system's reactions to a movement of the economy amplify the movement--inflation feeds upon inflation and debt-deflation feeds upon debt-deflation. Government interventions aimed to contain the deterioration seem to have been inept in some of the historical crises. These historical episodes are evidence supporting the view that the economy does not always conform to the classic precepts of Smith and Walras: they implied that the economy can best be understood by assuming that it is constantly an equilibrium seeking and sustaining system. (pg. 1)

Minsky’s financial instability hypothesis attempts to explain how debt deflationary spirals occur.
Minsky cites as influences for this hypothesis John Maynard Keynes’ General Theory and Joseph Schumpeter’s credit view of money.

As economic theory, the financial instability hypothesis is an interpretation of the substance of Keynes's "General Theory". This interpretation places the General Theory in history. …. The financial instability hypothesis also draws upon the credit view of money and finance by Joseph Schumpeter (1934, Ch.3)[.] (pg. 1 – 2)

Minsky’s hypothesis begins by dividing into three categories the financial posture an economic unit (e.g. a company, a government) can be positioned: 1) hedge finance, 2) speculative finance, 3) Ponzi finance.
These labels relate the outstanding debts of an economic unit with its ability to pay them off using its cash flows.

Three distinct income-debt relations for economic units which are labeled as hedge, speculative, and Ponzi finance, can be identified. (pg. 6)

A hedge finance unit is one that is in a position to pay off all of its debts using only its cash flows.
That is, it can meet any payments of interest and principal coming due without having to take on new debts.
Of the three financial postures an economic entity may by positioned in, hedge finance is the soundest.

Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows. (pg. 7)

A speculative finance unit is one whose cash flows can cover the interest payments coming due, but not payments of principal coming due.
Unable to pay off principal payments coming due using their cash flows, such units must continually roll over their debts.
That is, they must take on new debt to meet existing payments of principal which come due.
Economic entities in a speculative finance posture are therefore in a more precarious position than those in a hedge finance posture.

Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle out of income cash flows. Such units need to “roll over” their liabilities: (e.g. issue new debt to meet commitments on maturing debt). …. [B]anks are typically hedge units. (pg. 7)

Entities in the third financial posture are in the most precarious position.
An economic unit in a Ponzi finance posture is one that cannot afford to pay even the interest payments coming due on its outstanding debts, let alone meet any due payments of principal, using only its cash flows.
To continue operating, such entities must either sell assets or be able to borrow additional funds to meet both interest and principal payments coming due.
Not only is the entity in a Ponzi finance posture in a precarious position, but so too are its lenders: in order to be paid back, they are relying on the borrower in a Ponzi finance posture being able to roll over the entirety of its principal and interest payments coming due.

For Ponzi finance units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts. (pg. 7)

Having introduced these three categories, Minsky elaborates his financial instability hypothesis.
The first part of the hypothesis is that if hedge financing is the dominant financial posture of entities in an economy, then the economy is more stable.
On the other hand, as the number of economic entities in a speculative or hedge financing posture increases, so too does economic instability.

The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. (pg. 7 – 8)
It can be shown that if hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system. (pg. 7)

The second part of the theory is that financial instability can emerge, not merely as a result of exogenous shocks to an otherwise sound economy, but also endogenously from the internal dynamics at work in what may outwardly seem like a sound economy.
This is because, as a prolonged period of economic strength unfolds, economic entities tend to take on additional leverage: that is, an increasing number of economic entities move from a hedge financing posture to a speculative or Ponzi financing posture.
And the prevalence of speculative and Ponzi financing relations makes the economy unstable because numerous economic entities are now dependent on either selling assets or continually rolling over their debts in order to continue operating.
In short, according to Minsky’s financial instability hypothesis, periods of prolonged financial stability - and the risk-taking they give rise to - breed financial instability.
And this, for Minsky, is an internal feature of capitalist economies.

The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable financial system to financial relations that make for an unstable system. (pg. 8)
In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engages in speculative and Ponzi finance. (pg. 8)
The financial instability hypothesis is a model of a capitalist economy which does not rely upon exogenous shocks to generate business cycles of varying severity. The hypothesis holds that business cycles of history are compounded out of (i) the internal dynamics of capitalist economics, and (ii) the system of interventions and regulations that are designed to keep the economy operating within reasonable bounds. (pg. 8)

Written By: Aiden Singh Published: March 10, 2021

Source

Hyman Minsky. The Financial Instability Hypothesis. Levy Economics Institute Working Paper No. 74. May 1992.