what are the 3 stages of minsky's instability hypothesis

Minsky Moment

A sudden collapse of the market following a long period of unsustainable speculative activity involving high debt amounts taken by investors

What is a Minsky Moment?

A Minsky Moment is a sudden collapse of the market following a long period of unsustainable speculative activity involving high debt amounts taken by investors. The term is frequently used to discuss past and/or probable future financial crises .

It is named after an American economist, Hyman Minsky, who claimed that markets are susceptible to being unstable and long periods of good markets eventually end in larger crises.

• A Minsky Moment is the point in time that precedes a complete market crash.  Minsky Moments occur when investors engage in aggressive speculative activity and increase credit risks during extended prosperous times.
• Hyman Minsky argued that the markets are intrinsically unstable and swing between stability and instability periods.
• There are three phases of credit lending that lead to a Minsky Moment– hedge, speculative borrowing, and the Ponzi phase.

When Does a Minsky Moment Happen

When markets are good for an extended period of time, investors tend to keep borrowing and adding on risk in their portfolio. Investors continue taking on risk, speculating that the price of the asset will continue to increase.

However, when prices cease to rise, the investors have borrowed so much to obtain the assets that they do not have enough cash to pay off their debts. Lenders then call in the loan repayment, and therefore, investors start selling their assets. It can trigger a sudden collapse in the price of the assets, and the market witnesses a Minsky Moment.

Catalysts and Effects of a Minsky Moment

Investors engage in aggressive speculations during bull markets and borrow to capitalize on the market sentiments. The longer the bullish periods, the more debt owed by investors, and hence, more risk.

Assets acquired by investors generate cash, which is used to pay off the debt taken to acquire them. There comes a point when cash is not enough to compensate for the debt due to the decreasing value of leveraged assets. It happens because a slight retracement of the market, which is normal behavior, results in a decrease in the valuation of leveraged assets.

Consequently, debt issuers start to call in loans demanding repayments. As it is difficult to sell speculative assets, the investors are required to sell less speculative ones. It creates a market spiral, a sharp decline in liquidity, and an intensive cash demand in the market, which may require central banks to intervene.

The rapid decrease in credit volume leads to the inevitable collapse of the market. The market experiences a Minsky Moment at this point and can be followed by an extended period of market instability.

Phases Leading to a Minsky Moment

According to Hyman Minsky , an economy experiences three credit lending stages with risk levels increasing in each subsequent stage, which ultimately leads to a market crash:

1. Hedge Phase

The hedge phase is the most stable phase, where borrowers have enough cash flow from investments to cover both the principal and interest payments. In the hedge phase, lending standards continue to be high.

2. Speculative Borrowing Phase

In the speculative borrowing phase, cash flows from investments cover only the borrower’s interest payments , not the principal. Investors are speculating that the value of their investments will continue to increase, and the interest rates will not rise.

3. Ponzi Phase

The Ponzi phase is the riskiest in the cycle. The borrowers’ cash flows from their investments are not enough to cover the interest and principal payments. Investors borrow, believing that the rising asset value will allow them to sell the assets at higher prices, enabling them to pay off or refinance their debt.

The Ponzi phase is characterized by a high valuation of assets. Currently, the non-financial corporate debt of the U.S., when measured as a percentage of GDP , is higher than it was before the last financial crisis.

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Minsky Moment

The onset of a market collapse is followed by reckless speculative activity involving high debt amounts taken by investors.

Audencia Winter Exchange | MBA 2022-24

• What Is A Minsky Moment?

Understanding Minsky Moment

• Hyman Minsky's Financial Instability Hypothesis
• Phases Leading To A Minsky Moment
• Catalysts And Effects Of A Minsky Moment
• How Minsky Moment Can Help Us Be Better Investors

What is a Minsky Moment?

The Minsky Moment is the onset of a market collapse which is followed by reckless speculative activity involving high debt amounts taken by the investors. This term is frequently used to discuss past or future financial crises.

It is named after an American economist, Hyman Minsky , who defined it as the time when there was a sudden decline in the market that inevitably led to a market collapse that eventually led to a larger economic crisis.

This crisis generally occurs when investors take part in excessively aggressive speculative activity and increase credit risk during a prosperous time in the market.

According to Hyman Minsky, markets are completely unstable and oscillate between stable and unstable periods.

It is the peak point when speculative activities reach an unsustainable extreme, leading to an unpreventable market collapse and rapid price deflation.

According to the hypothesis, rapid instability occurs because extended periods of steady investment gains and prosperity encourage a diminished perception of market risk, which promotes the risk of investing borrowed money instead of cash.

The repetitive chain of Minsky moments is the general concept of a “Minsky Cycle”.

Hyman Minsky, an economist, argues that markets (particularly bull markets) have the general characteristic of being unstable. The term " bull market” denotes a period during which the market experiences a sudden increase.

It refers to a moment of time when there is a sudden increase in a major crisis of asset values, resulting in an increase in debt. 

It is based on the idea that if the period of bullish speculation extends, then it will gradually result in a crisis, and the longer this period extends, the worse the crisis.

An accurate example of this moment is the financial crisis of the year  2008. At the peak of this financial crisis, a substantial number of markets assumed they were at their all-time lows, eventually leading to the selling of assets to cover market debts and higher default rates.

Key Takeaways

• A Minsky Moment is a sudden market collapse that follows an extended period of bullish activity driven by unsustainable speculation and debt.
• Minsky's hypothesis states that periods of economic stability and rising asset prices lead to increased risk-taking and borrowing, eventually resulting in a sharp market correction or financial crisis.
• A Minsky Moment is triggered when borrowers can no longer meet their debt obligations, leading to a cascade of asset sales, plummeting prices, and widespread panic.
• During a Minsky Moment, the rapid unwinding of speculative positions and forced asset sales can lead to significant declines in market value, increased volatility, and a loss of confidence among investors.

A Minsky Moment is based on the idea that if these periods of bullish speculation last for a long time, this will eventually lead to an economic crisis, and the longer this period of bullish speculation occurs, the more severe this crisis will be.

Hyman Minsky’s main theory of this economic theory was centered around the concept of market instability, especially in bull markets. He felt that long periods of bull markets ended in cataclysmic crashes.

According to Hyman, an abnormally long period of bullish economic growth causes an unprecedented asymmetric rise in market speculation, eventually leading to a market crisis and instability. 

It is also associated with high amounts of debt taken on by both institutional and retail investors, followed by prolonged periods of bullish speculation.

The term “Minsky Moment” was coined by Paul McCulley in 1998 to describe the Afghan Crisis of 1997 . This crisis was caused due to the pressure on dollar-pegged Asian currencies by others, which eventually caused the fall of the same currencies.

Retail and institutional investors may decide to take more credit during this promising market period after increasing, which leads to a sudden change in market value , eventually leading to the fall of the market. Therefore, it is called the Minsky Moment.

When the markets are good and profitable for a long period of time, investors keep on borrowing money and adding risk to their portfolios. They continue to take on risks, speculating that the prices will continue to increase.

However, when asset prices stop rising, the investors will have borrowed so much money that they will have no cash left to pay off their debts.

When the lenders call in for their loan repayment, the investors have to start selling their assets to repay the loans. However, this can immediately trigger a collapse in the prices, and the market witnesses the above-mentioned moment.

Hyman Minsky's Financial Instability Hypothesis

According to an assumption based on underlying classical economic theory, the economy seeks equilibrium and is fundamentally stable.

The theory suggests that when there is an excess, the rational market sees it and finds a way to either make money or lose it, thereby moving the economy back to equilibrium.

According to this theory, diseases, wars, and technological advances are external shocks to the economy. These are the bubbles that can cause potential crashes in the economy.

Hyman Minsky proposed a theory labeled the " financial instability hypothesis " that holds that the economy will create its own bubbles and crashes.

The gist of his theory is that a stable economy sows its own seeds of destruction because stability leads people to take risks. This risk-taking nature creates financial instability, eventually resulting in crisis and panic.

Unfortunately, neither Minsky nor his theory were taken seriously during his lifetime. He died in 1996, before the Great Recession and the dot-com bubble, both of which validated his theory. His theory is now accepted as the primary explanation for the boom-and-bust cycles in the economy.

This theory is rooted in the excessive risk-taking and the panic that follows when this risk-taking fails, and the economy collapses. Increased risk-taking causes an increase in debt. 

There are three stages that led to this moment: the hedge phase, the speculative phase, and the Ponzi phase.

The key insight is that stability in itself is destabilizing because, during times of economic stability, healthy investments lead to euphoria, overextended debt, and increased financial leverage , eventually causing a Minsky Moment that leads to recession or even a financial crisis .

Phases leading to A Minsky moment

Hyman Minsky’s Financial Instability Hypothesis postulated that there are three phases that lead to a Minsky Moment. These are three credit lending stages, with risk levels increasing in each subsequent stage that finally ends with a market collapse or bubble burst.

The three credit lending phases are explained below:

Hedge Phase

It is the first phase of the Minsky Theory. It is the most stable phase of total debt in the economy. The market is characterized by strict credit policies and high lending standards, along with memories of recent collapses.

Borrowers can use cash flow from investments to meet the principal and interest expenses. 

Hedge Financing Units can fulfill all the payment obligations with their cash flow: the greater the weight of equity financing , the greater the possibility of it being a hedge financing unit.

Hedge units are typically governments with floating debts, banks, or corporations with floating issues of commercial paper .

Speculative Borrowing Phase

This phase follows the hedge phase. In the speculative borrowing phase, cash flow from the investments can be used to cover only the borrower’s interest payments , not the principal.

The level of debt increases while profit rises, the economy starts rising, and the credit guidelines are loosened.

According to the investors, the investment values will continue to rise, but the interest rates will not. Borrowers meet their interest expenses, but the repayment of the principal will be stressful from the investment income.

Speculative finance units are able to meet their payment commitments even if they cannot repay the principal out of cash flow. Such units need to roll over their liabilities.

Ponzi Phase

This is the phase before the bubble bursts or the market collapses and is the riskiest phase in the cycle. The cash flow from the investments is not enough to cover the principal payments and interest.

This phase exhibits optimistic people making irrational decisions and taking risky decisions. Investors believe that the value of assets will rise to allow them to sell the assets at higher prices, enabling them to pay off their debts. Therefore, they borrow money.

This phase is characterized by high debt, high risk-taking activities, high asset values, and an increase in the sale of assets. Still, the borrowers find it difficult to pay off their interest expenses and principal.

Finally, these events led to the collapse of the market and subsequent recession.

Catalysts and Effects of a Minsky Moment

It generally occurs when investors engage in excessively aggressive speculation and take on excess credit risk during prosperous times or bull markets. Investors borrow to capitalize on market sentiments.

The longer a bull market extends, the more debt is taken on by the investors, and hence, there is more risk. This decreases the prices of assets from speculation, finally resulting in margin calls and credits being unpaid, affecting borrowing rates across the market.

The Minsky Moment defines the peak point at which speculative activities reach an extreme, leading to the rapid decline in prices and the unpreventable collapse of the market. This is followed by an extended period of instability.

Cash is generated by the assets acquired by investors, which are used to pay off the debt that was taken to acquire them. A point arrives when there is not enough cash to compensate for the debt due to the decreased value of assets under leverage.

It happens due to a slight retracement of the market, which is normal behavior, eventually resulting in the decreased values of leveraged assets.

As a result, debt collectors begin to make calls about loan repayments. It is already difficult to sell speculative assets, so investors are required to sell fewer speculative assets. 

This creates a market spiral, a sharp decline in liquidity, and increased cash demand in the market that might require central banks to intervene.

The inevitable collapse of the market is caused by the rapid decrease in credit volume. The market then follows a long period of market instability.

For example, an investor borrows funds to invest when the market is in a prosperous time or a bull market. But when the market comes down for a bit, the leveraged assets might not be able to pay off the debts. 

When lenders begin to demand debt repayment, investors will be forced to sell off less speculative assets in order to repay the loans. The sale of these assets causes the market to decrease.

How Minsky Moment can Help us be Better Investors

Hyman Minsky’s financial instability hypothesis is an essential model for all of us to have in our toolkits. This hypothesis has three cycles, and they each have their own characteristics, lengths, and risks.

The state of euphoria and panic lasts longer than we expect it to end. Outside shocks such as pandemics, earthquakes, geopolitical events, and any other natural or man-made disaster can also have big effects.

It is impossible to predict precisely when the economy will transition from one part of the cycle to another or how long each cycle will last.

If we have a rough estimate of our position in the cycle, then investors and business owners can come up with good strategies. 

As the markets and economy move from a state of boom to euphoria, it's very essential to have a healthy margin of safety in the form of cash and high-quality bonds .

Smart businesses increase their cash to shore up their liquidity and they resist the temptation of taking up debts too. 

Then, when the stage of panic and profit-taking occurs, the smart business owners can redeploy their safety margins (cash or high-quality bonds) into bargain-priced risk assets.

The financial instability hypothesis by Hyman Minsky is full of lessons, but the most essential one to remember is to avoid being caught up in the dread of the panic phase of the cycle or the greed of the euphoric phase of the cycle.

However, it is impossible to foresee the transition phase of the cycle or to precisely time market tops and bottoms.

However, recognizing where we are in the cycle may help us stick to a better investment strategy and avoid following the others full speed into a bust.

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The minsky moment: why stability leads to panic and what to do about it.

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We all know that the economy moves in cycles; boom is followed by bust is followed by boom seemingly forever. A question we’d all like the answer to is: “Where are we now in the cycle?” Economist Hyman Minsky’s “financial instability hypothesis” helps answer this question.

Classical Economics Assumes the Market is Fundamentally Stable

An assumption underlying classical economic theory is that the economy is fundamentally stable and seeks equilibrium. The theory holds that as excesses occur, rational market actors see the excesses and act to make money or avoid losing it, and thereby move the economy back toward equilibrium.

According to this theory, bubbles and crashes are caused by external shocks to the economy such as disease, wars, and technological discoveries. While external shocks, such as the OPEC oil embargo of the 1970s or the current pandemic, certainly have significant economic effects, they don’t adequately explain the sequence of booms and busts that we have seen. The dotcom bust of 2000 and the financial crisis of 2008 weren’t caused by external shocks; they illustrate that the economy is not fundamentally stable.

Minsky Proposed that the Market is Fundamentally Unstable

Hyman Minsky was an economist at Washington University in St. Louis from 1965 to 1990. He proposed a theory he labeled the financial instability hypothesis, which holds that the economy creates its own bubbles and crashes. The gist of his theory is that stable economies sow the seeds of their own destruction because stability, seeming safe, encourages people to take risks. That risk-taking creates financial instability that eventually results in panic and crisis.

Unfortunately, during his lifetime, neither Minsky nor his hypothesis was taken seriously. He died in 1996, before the dotcom bubble and the Great Recession, both of which gave credence to his ideas. His theory is now accepted as a primary explanation for the boom-and-bust cycles in the economy.

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The financial instability hypothesis is rooted in swings between excessive risk-taking and the panic that follows when the risk-taking overheats and the economy collapses. Increased risk in the economy can be seen in the terms on which debt is incurred. Minsky hypothesized three stages of lending he dubbed hedge, speculative, and Ponzi.

During the hedge stage, lenders and borrowers are cautious because of the losses they incurred in the prior recession. Borrowers are wary of leverage, and lenders make loans in modest amounts with stringent credit requirements. During this stage, the amount of debt in the system is reasonable.

In the following speculative stage, market participants become more confident of a recovery. Borrowers take on greater amounts of debt, and the economy begins to boom. Lenders grant credit based on ever-lower standards, assuming that asset prices will continue to rise. During this stage, borrowers can cover the interest on the loans, but become less able to repay the principal.

By the final Ponzi stage, lenders and borrowers have forgotten the lessons of the prior crisis. Everyone is sure that asset prices will continue to rise, and debt is granted with repayments based on that assumption. The economy becomes over-leveraged; debt and risk-taking have created a financial house of cards.

Finally, a “Minsky Moment”—as the Paul McCulley of PIMCO dubbed it—occurs. Market insiders take profits, everyone panics, and a crash ensues before the cycle starts over.

The key insight of Minsky’s model is that stability itself is destabilizing (see figure below) because during times of economic stability, healthy investments lead to speculative euphoria, increasing financial leverage, and over-extending debt, eventually resulting in a Minsky Moment, which leads to a recession or even a financial crisis.

Minsky's Cycle of the Economy

Paradoxically, Minsky’s hypothesis teaches us that the time of greatest investment risk is when everything seems good, and investing is actually least risky when, as Baron Rothschild once put it, there is “blood in the streets.”

How Minsky Can Help Us Be Better Investors

Minsky’s financial instability hypothesis is an essential mental model for us to have in our toolkit. Each cycle has its own characteristics and length. Euphoria and panic can both last longer than we might expect. And outside shocks such as a pandemic or geopolitical events can have big effects as well. So, we can’t predict with precision when the economy will transition from one part of the cycle to the next.

But knowing roughly where we are in the cycle can inform good strategies for investors and business owners. As the economy and markets move from boom to euphoria, it’s essential to have a healthy margin of safety in the form of cash and high-quality bonds. Smart businesses will increase their cash to shore up liquidity and resist the temptation to take on more debt. Then when the profit-taking and panic occur, they can redeploy their safety margin into bargain-priced risk assets.

The most important lesson to take from Minsky’s hypothesis is not to get caught up in the fear that comes with the panicky part of the cycle, or the greed that accompanies the euphoria. While it’s not possible to accurately time the tops and bottoms of the market, knowing roughly where we are in the cycle may help you stick with your investment strategy and avoid following the herd at full speed into a bust.

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The Minsky Moment

Twenty-five years ago, when most economists were extolling the virtues of financial deregulation and innovation, a maverick named Hyman P. Minsky maintained a more negative view of Wall Street; in fact, he noted that bankers, traders, and other financiers periodically played the role of arsonists, setting the entire economy ablaze. Wall Street encouraged businesses and individuals to take on too much risk, he believed, generating ruinous boom-and-bust cycles. The only way to break this pattern was for the government to step in and regulate the moneymen.

Many of Minsky’s colleagues regarded his “financial-instability hypothesis,” which he first developed in the nineteen-sixties, as radical, if not crackpot. Today, with the subprime crisis seemingly on the verge of metamorphosing into a recession, references to it have become commonplace on financial Web sites and in the reports of Wall Street analysts. Minsky’s hypothesis is well worth revisiting. In trying to revive the economy, President Bush and the House have already agreed on the outlines of a “stimulus package,” but the first stage in curing any malady is making a correct diagnosis.

Minsky, who died in 1996, at the age of seventy-seven, earned a Ph.D. from Harvard and taught at Brown, Berkeley, and Washington University. He didn’t have anything against financial institutions—for many years, he served as a director of the Mark Twain Bank, in St. Louis—but he knew more about how they worked than most deskbound economists. There are basically five stages in Minsky’s model of the credit cycle: displacement, boom, euphoria, profit taking, and panic. A displacement occurs when investors get excited about something—an invention, such as the Internet, or a war, or an abrupt change of economic policy. The current cycle began in 2003, with the Fed chief Alan Greenspan’s decision to reduce short-term interest rates to one per cent, and an unexpected influx of foreign money, particularly Chinese money, into U.S. Treasury bonds. With the cost of borrowing—mortgage rates, in particular—at historic lows, a speculative real-estate boom quickly developed that was much bigger, in terms of over-all valuation, than the previous bubble in technology stocks.

As a boom leads to euphoria, Minsky said, banks and other commercial lenders extend credit to ever more dubious borrowers, often creating new financial instruments to do the job. During the nineteen-eighties, junk bonds played that role. More recently, it was the securitization of mortgages, which enabled banks to provide home loans without worrying if they would ever be repaid. (Investors who bought the newfangled securities would be left to deal with any defaults.) Then, at the top of the market (in this case, mid-2006), some smart traders start to cash in their profits.

The onset of panic is usually heralded by a dramatic effect: in July, two Bear Stearns hedge funds that had invested heavily in mortgage securities collapsed. Six months and four interest-rate cuts later, Ben Bernanke and his colleagues at the Fed are struggling to contain the bust. Despite last week’s rebound, the outlook remains grim. According to Dean Baker, the co-director of the Center for Economic and Policy Research, average house prices are falling nationwide at an annual rate of more than ten per cent, something not seen since before the Second World War. This means that American households are getting poorer at a rate of more than two trillion dollars a year.

It’s hard to say exactly how falling house prices will affect the economy, but recent computer simulations carried out by Frederic Mishkin, a governor at the Fed, suggest that, for every dollar the typical American family’s housing wealth drops in a year, that family may cut its spending by up to seven cents. Nationwide, that adds up to roughly a hundred and fifty-five billion dollars, which is bigger than President Bush’s stimulus package. And it doesn’t take into account plunging stock prices, collapsing confidence, and the belated imposition of tighter lending practices—all of which will further restrict economic activity.

In an election year, politicians can’t be expected to acknowledge their powerlessness. Nonetheless, it was disheartening to see the Republicans exploiting the current crisis to try to make the President’s tax cuts permanent, and the Democrats attempting to pin the economic downturn on the White House. For once, Bush is not to blame. His tax cuts were irresponsible and callously regressive, but they didn’t play a significant role in the housing bubble.

If anybody is at fault it is Greenspan, who kept interest rates too low for too long and ignored warnings, some from his own colleagues, about what was happening in the mortgage market. But he wasn’t the only one. Between 2003 and 2007, most Americans didn’t want to hear about the downside of funds that invest in mortgage-backed securities, or of mortgages that allow lenders to make monthly payments so low that their loan balances sometimes increase. They were busy wondering how much their neighbors had made selling their apartment, scouting real-estate Web sites and going to open houses, and calling up Washington Mutual or Countrywide to see if they could get another home-equity loan. That’s the nature of speculative manias: eventually, they draw in almost all of us.

You might think that the best solution is to prevent manias from developing at all, but that requires vigilance. Since the nineteen-eighties, Congress and the executive branch have been conspiring to weaken federal supervision of Wall Street. Perhaps the most fateful step came when, during the Clinton Administration, Greenspan and Robert Rubin, then the Treasury Secretary, championed the abolition of the Glass-Steagall Act of 1933, which was meant to prevent a recurrence of the rampant speculation that preceded the Depression.

The greatest need is for intellectual reappraisal, and a good place to begin is with a statement from a paper co-authored by Minsky that “apt intervention and institutional structures are necessary for market economies to be successful.” Rather than waging old debates about tax cuts versus spending increases, policymakers ought to be discussing how to reform the financial system so that it serves the rest of the economy, instead of feeding off it and destabilizing it. Among the problems at hand: how to restructure Wall Street remuneration packages that encourage excessive risk-taking; restrict irresponsible lending without shutting out creditworthy borrowers; help victims of predatory practices without bailing out irresponsible lenders; and hold ratings agencies accountable for their assessments. These are complex issues, with few easy solutions, but that’s what makes them interesting. As Minsky believed, “Economies evolve, and so, too, must economic policy.” ♦

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Minsky, the Financial Instability Hypothesis, and Risk Management

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• Hersh Shefrin  

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A t this point we turn our attention to risk management in the financial sector. The next several chapters apply the concepts developed to analyze the psychological dimension of risk management at major financial institutions that were at the heart of the global financial crisis. This chapter sets the stage by providing a general framework for understanding financial instability from a macroprudential perspective, in which macroprudential is understood as referring to the welfare of the financial system as a whole. To do so, the chapter presents the insights of acclaimed economist Hyman Minsky, who died in 1996. Minsky’s study and analysis of the causes and consequences of financial fragility, financial crises and economic instability are unparalleled. 1

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See Hyman Minsky (1986), reprinted in 2008. Stabilizing an Unstable Economy (New York: McGraw-Hill). The original publication date for this book occurred as a financial crisis was developing in the savings and loan

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This chapter draws from my previous writings. See Hersh Shefrin and Meir Statman (2012), “Behavioral Finance in the Financial Crisis: Market Efficiency, Minsky, and Keynes,” in Rethinking the Financial Crisis , ed. Alan Blinder, Andrew Lo, and Robert Solow (New York: Sage Foundation/Century Foundation), 99–135. Also see Hersh Shefrin (forthcoming), “Assessing Hyman Minsky’s Insights,” in The Global Financial Crisis: Economics, Psychology, and Values , ed. A. G. Malliaris, L. Shaw, and H. Shefrin (New York: Oxford University Press).

For information about the financial crisis, I draw on several sources. See Financial Crisis Inquiry Report , 2011. Washington, DC: US Government Printing Office, available at http://fcic.law.stanford.edu/and Martin Wolf (2014), The Shifts and the Shocks (London: Penguin Press HC).

See John Coates (2012), The Hour between Dog and Wolf: How Risk Taking Transforms Us, Body, and Mind (New York: Penguin).

See Susan Greenfield (2015), Mind Change: How Digital Technologies Are Leaving Their Mark on Our Brains (New York: Random House).

Paul McCulley (2009), “The Shadow Banking System and Hyman Minsky’s Economic Journey,” in Insights into the Global Financial Crisis , ed. Laurence B. Siegel. (Charlottesville: Research Foundation of CFA Institute), 224–256.

See Alan Blinder (2013). After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead. (New York: Penguin). The discussion about “Mr. Bailout” appears on p. 123. In his book and in later writings, Blinder is unequivocal in his view that Minsky was right. See Alan Blinder (2015), “Can Economists Learn? The Right Lessons From the Financial Crisis,” Foreign Affairs March-April, https://www.foreignaffairs.com/reviews/review

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Shefrin, H. (2016). Minsky, the Financial Instability Hypothesis, and Risk Management. In: Behavioral Risk Management. Palgrave Macmillan, New York. https://doi.org/10.1057/9781137445629_7

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Minsky’s Financial Instability Hypothesis and Modern Economics

Hyman Philip Minsky (b. 23 September 1919, d. 24 October 1996) was best known for his Financial Instability Hypothesis of the business cycle, which emphasized the dynamics of business investment finance as a recurring cause of macroeconomic instability (Minsky 1972, 1980). During a boom, the expansion of debt-financed investment spending causes initial “robust” financial structures to evolve into “fragile” financial structures, and it is this evolution that ultimately brings the expansion to an end. In the subsequent contraction, typically some fragile financial structures collapse while others are refinanced into more robust financial structures, thereby creating the preconditions for renewed expansion.

A central reason for policy intervention in this boom-bust process, Minsky emphasized, is the ever-present danger that the contraction will get out of control and spread into a system-wide debt-deflation. In this way, a normal business recession can become instead a deep and long-lasting depression, such as happened in 1929-1933 when debt deflation brought down the US banking system and ushered in a depression that did not end until World War II, notwithstanding all the attempts of Roosevelt’s New Deal. Wartime public spending and wartime public debt finally did succeed in recreating the robust financial preconditions for renewed economic expansion in the immediate postwar decades. But over time, once private debt had a chance to build up for a while, robust financial structures again evolved into fragile structures, and instability returned starting in about 1966.

Unfortunately, the return of instability coincided also with the ascendancy of a new interventionist orthodoxy in economic theory which, extrapolating from the entirely unusual circumstances of the immediate postwar, attributed business fluctuations not to changing financial structures but rather simply to fluctuations in aggregate demand. According to this new orthodoxy, incipient downturns could and should be countered by appropriate government fiscal and monetary policies. Government spending could maintain aggregate demand directly, and/or tax cuts and subsidies could stimulate private consumption and investment indirectly, so as to maintain aggregate income near the level of full employment.

In the short run, this policy orthodoxy achieved its stated goal, but in the longer run it acted to block the natural process of restoring robust finance, with the consequence that an increasingly fragile financial structure served as an increasing obstacle to capital investment and hence also to robust economic performance. Because of government intervention there was no debt deflation and no great depression, but rather stagnation and inflation during the decade of the 1970s. Finally, the extraordinary tight monetary policy of 1979-1982 under Paul Volcker turned the tide and created the financial precondition for renewed expansion in the decade to follow (Minsky 1986). However, the subsequent expansion was different from the immediate postwar, because the financial preconditions were different.

What followed after Volcker was a new kind of institutional arrangement that Minsky called “money manager capitalism”, driven by a new breed of institutional investors in pension funds, insurance companies, and mutual funds. Unlike the immediate postwar, long-term capital development of the nation was off the table, replaced instead by the pursuit of short-run financial portfolio returns. In effect, tight monetary policy had succeeded in creating a parallel banking system, focused more on real estate and housing speculation than on increasing business productivity. Minsky viewed the financial crisis of 1987 as a first crisis of this new system. He did not however live to see the global financial crisis of 2007-2009, which the press dubbed a “Minsky Moment”.

Intellectual Formation

Minsky got his start in economics at the University of Chicago, where he enrolled in September 1937 in the middle of the Great Depression. There is no reason to doubt Minsky’s own assessment that two Chicago professors, Oscar Lange and Henry Simons, were the most significant early influences on his thought (Minsky 1985). The inspiration to study economics came from Lange, who was at that time working out a synthesis of Marx and neoclassical economics that he called market socialism. Henry Simons was the source of Minsky’s lifelong interest in finance, as well as the idea that the fundamental flaw of modern capitalism stemmed from its banking and financial structure. Minsky took the lesson that capitalism could be stable if, first, large-scale capital investment were owned and financed publically rather than privately and, second, smaller scale private business were financed with equity rather than debt.

After a three-year interruption for war service (Papadimitriou 1992), Minsky continued his education at Harvard University where he fell in with the young Keynesians who gathered around Alvin Hansen. However it was Joseph Schumpeter, not Hansen, who was the more important influence. A “conservative Marxist”, as Minsky would later characterize his mentor, Schumpeter’s earliest work on the Theory of Economic Development (1912) had emphasized the importance of money creation by the banking system as the crucial source of entrepreneurial finance. Banks can and do lend by creating deposits, which serve as purchasing power that entrepreneurs use to acquire the real resources they need in order to make their future plans into present realities. This mechanism, according to Schumpeter, is the source of the dynamism of capitalism, just as it is also, according to Simons, the source of capitalism’s instability.

Minsky’s 1954 PhD thesis “Induced investment and business cycles” represents his attempt to insert his concerns about finance into the then-standard Hansen-Samuelson accelerator-multiplier model, which has no finance in it. Viewed in retrospect, the more fundamental contribution Minsky made in his thesis was to conceive of ordinary business firms as akin to banks, insofar as they can be seen fundamentally as cash inflow-outflow operations that confront both solvency and liquidity “survival constraints” (1954, p. 157-162). From this point of view, the natural accounting structure for the economic system is not the National Income and Product Accounts, which served as the empirical basis for the Hansen-Samuelson model, but rather the newer Flow of Funds accounts developed by American institutionalist Morris Copeland (1952). In effect, Minsky’s mature Financial Instability Hypothesis would build on this alternative empirical basis, though Minsky goes beyond the Flow of Funds accounts to emphasize the time-dated pattern of cash commitments embedded in the structure of outstanding debts of various kinds (Minsky 1964).

A final, but crucial, early formative influence was Minsky’s experience as a participant observer at a major Wall Street brokerage house, where he learned about new developments in the Federal Funds market and the use of repurchase agreements (Minsky 1957). He concluded from that experience that the goal of using monetary policy for aggregate stabilization was probably illusory on account of the attendant financial innovation. The central bank could try to limit the supply of public bank reserves, as a way of holding back expansion, but the result would only be to encourage banks to develop their own private mechanisms for economizing on scarce reserves. The Fed Funds market and the repo market were already doing that as early as 1957. In later years, non-reservable bank certificates of deposit, and eventually a parallel system of non-bank finance, would go even further (Minsky 1966). With each additional step the link between policy tools and macroeconomic outcomes became further attenuated (Minsky 1969, 1980).

The Financial Instability Hypothesis

At the very center of Minsky’s conception of what makes a financial structure robust or fragile is the relationship between the time pattern of cash commitments and the time pattern of expected cash flows. A firm with cash flows greater than cash commitments for every future period is said to be engaged in “hedge” finance, because the unit can meet its commitments from its own resources. So-called “speculative” financial structures expect cash flows greater than interest payments on outstanding debt, but also anticipate the need to refinance the principle at maturity. That makes the firm vulnerable in the event that refinance turns out to be unexpectedly expensive or even unavailable. So-called “Ponzi” financial structures are even more vulnerable since they anticipate cash flows insufficient even to cover interest payments, so refinance depends on capital gains in the underlying investment as well as general financial conditions.

The core idea of the Financial Instability Hypothesis is that there is a built-in tendency for the system to shift over time from robust “hedge” financial structures to fragile “speculative” and “Ponzi” financial structures. A central driver of this tendency is the apparent cheapness of short term finance relative to long term finance, a consequence of liquidity preference which means that wealth holders are willing to accept a lower yield on assets that are more readily (or imminently) turned into current cash. Thus it is always tempting to finance long-lived capital assets with short-term debt, planning to roll over the debt at maturity into another short-term debt. That temptation pushes firms from hedge to speculative finance.

The temptation is always there, but in the immediate aftermath of a contraction that has visibly involved the collapse of fragile financial structures, both borrowers and lenders are able to resist the temptation. Liquidity risk is on their minds. Thus, it is only gradually over time that robust financial structures give way to fragile financial structures, as evidence accumulates that giving in to temptation is once again a profitable strategy, for both borrowers and lenders. Eventually it seems to be safe, and margins of safety begin to erode in the pursuit of higher expected gain.

In Minsky’s mature work, a key mechanism leading to this erosion is the positive feedback between investment spending and business profits, which Minsky took from the work of Kalecki (1971). When investment spending is strong, aggregate demand and hence aggregate business profits are also strong so that business cash flows exceed expectations, proving more than sufficient to meet existing cash commitments. Thus the lesson is learned that previous caution was excessive, and thus the road is opened for a shift to more fragile finance. And of course the same mechanism works the opposite way on the way down, as lower investment leads to lower profit than expected and hence greater than expected difficulty in meeting cash commitments.

Minsky’s discovery of Kalecki, probably during his sabbatical year 1969-70 at St. Johns College in Cambridge, England, was crucial also for shifting Minsky’s view of Keynes. Back at Harvard, the Keynes that Minsky had learned was supposed to be about a liquidity preference theory of money demand, which interacted with an exogenously fixed money supply to set the rate of interest. There was nothing much in that Keynes for Minsky, with his Simons-Schumpeter vision of integral role of elastic bank finance for business investment, a commercial loan model of the (endogenous) money supply rather than Keynes open market operations (exogenous) money model. By contrast, although Kalecki’s Marxism was not the conservative type favored by Schumpeter, it was a familiar frame and it was through that frame that Minsky found his way to Keynes.

In his subsequent book John Maynard Keynes (1975), Minsky finally embraced Keynes in words that could apply equally to himself: “The knowledgeable view of the operation of finance that Keynes possessed was not readily available to academic economists, and those knowledgeable about finance did not have the skeptical, aloof attitude toward capitalist enterprise necessary to understand and appreciate the basically critical attitude that permeated Keynes’s work” (p. 130). In the end, Minsky came to think of his own financial instability hypothesis as a completion of Keynes’ work by filling in the details of the financial system, the “logical hole” (p. 63) that Keynes left out in his own academic formulations.

Reading Keynes with his new understanding that Keynes, like himself, was always looking at the world through the lens of banking—the “Wall Street” or “City” view–led Minsky to formulate what he called his “two-price theory of investment”. Contra the quantity theory of money, monetary conditions do not drive the price of output; but they do drive the price of capital assets. The kind of liquidity-stretching innovations that banks use to overcome central bank constraint (as Minsky 1957) not only enable them to provide the investment finance demanded by their business clients, but also operate directly to stimulate that demand through their effect on the price of existing capital assets. Specifically, creation of private liquidity to satisfy demand for liquidity preference lowers the premium required to hold illiquid capital assets, and hence drives up their price. Subsequently, a widening gap between the price of existing capital assets and the current output price of new capital assets provides incentive to add new capital assets to the old, which is investment. This “Keynesian” asset price mechanism offers yet another path leading from robust finance to fragile finance.

Minsky’s Simons-Schumpeter-Kalecki-Keynes view of the world put him at odds with the postwar monetary Walrasian orthodoxy of Patinkin-Tobin-Modigliani. Whereas orthodoxy emphasized the use of monetary policy to “control” aggregate fluctuation, Minsky always emphasized instead the “support” function as lender of last resort in a crisis and market maker in normal times. Regular engagement with market participants through the discount window would, Minsky thought, allow the central bank to shift the balance a bit toward hedge finance by favoring robust structures in its collateral policy. Toward that end, he urged widening access to the discount window in normal times to include a broader cross-section.

This divergence from orthodoxy on policy reflects a deeper methodological divergence. Whereas postwar economic orthodoxy characteristically operated within an intellectual frame of market equilibrium, even intertemporal market equilibrium, with abstract individual agents making rational intertemporal allocation decisions, Minsky characteristically operated closer to the lived reality that actual agents confront, namely an open-ended future that is substantial uncertain (not just risky) and a present choice set that is substantially constrained by survival constraints of various kinds. Minsky’s agents are not irrational, but rather more like Schumpeter’s constructive entrepreneurs who imagine a possible future and then use their cash inflow-outflow interface with the economic system to acquire resources in an attempt to make that imagined future a present reality. In a world like this, it matters a lot which agents get the chance to make that attempt; it matters for the capital development of the nation.

Minsky’s financial instability hypothesis was designed to explain the times he was living in, not so much the post-Volcker era of money manager capitalism. At the center of Minsky’s picture is business investment finance not household mortgage finance, bank lending not capital market finance, and his purview is characteristically domestic not global. But the analytical apparatus he developed is more general. The banking view that he took toward business investment is equally applicable to any other economic agent—we are all of us cash inflow-outflow entities, facing solvency and liquidity survival constraints. Similarly applicable is Minsky’s emphasis, at the level of the system as a whole, on the shifting match between the time pattern of cash commitments that is embedded in the existing structure of debt as compared to the time pattern of expected cash flow to fulfill those commitments.

Copeland, Morris A. 1952. A Study of Money-flows in the United States. New York: National Bureau of Economic Research. Kalecki, M. 1971. Selected Essays on the Dynamics of the Capitalist Economy (1933-1970). Cambridge, UK: Cambridge University Press. Minsky, Hyman P. 1954. “Induced investment and business cycles.” Unpublished PhD dissertation, Department of Economics, Harvard University. Minsky, Hyman P. 1957. “Central banking and money market changes.” Quarterly Journal of Economics 71 (2): 171-187. Reprinted as Ch. 7 in Minsky (1982). Minsky, Hyman P. 1964. “Financial Crisis, Financial Systems, and the Performance of the Economy”. Pages 173-380 in Private Capital Markets. Commission on Money and Credit Research Study. Englewood Cliffs, NJ: Prentice Hall. Minsky, Hyman P. 1969. “The New Uses of Monetary Powers.” Nebraska Journal of Economics and Business 8. Reprinted as Ch. 8 in Minsky (1982). Minsky, Hyman P. 1972. “Financial Instability revisited: the economics of disaster.” In Reappraisal of the Federal Reserve Discount Mechanism, Board of Governors, Federal Reserve System. Reprinted as Ch. 6 in Minsky (1982). Minsky, Hyman P. 1975. John Maynard Keynes. New York: Columbia University Press. Minsky, Hyman P. 1980. “Finance and Profits: the changing nature of American business cycles.” In The Business Cycle and Public Policy 1929-1980: A Compendium of Papers submitted to the Joint Economic Committee. Congress of the United States, 96th Congress, 2nd Session. Washington, DC: Government Printing Office. Reprinted as Ch. 2 in Minsky (1982). Minsky, Hyman P. 1980. “The Federal Reserve: Between a Rock and a Hard Place.” Challenge 23 (May/June), 30-36. Reprinted as Ch. 9 in Minsky 1982. Minsky, Hyman P. 1982. Can ‘It’ Happen Again? Essays on Instability and Finance. Armonk, NY: ME Sharpe. Minsky, Hyman P. 1985. “Beginnings.” Banca Nazionale del Lavoro Quarterly Review 154: 211-221. Minsky, Hyman P. 1986. Stabilizing an Unstable Economy. Twentieth Century Fund Report. New Haven and London: Yale University Press. Papadimitriou, D. B. 1992. “Minsky on himself.” Pages 13-26 in Essays in Honor of Hyman P. Minsky, edited by S. Fazzari and D. B. Papadimitriou. Armonk, NY: ME Sharpe.

The Minsky Moment: Why Stability Leads to Market Panic and What to Do About It

We all know that the economy moves in cycles; boom is followed by bust is followed by boom seemingly forever. A question we’d all like the answer to is: “Where are we now in the cycle?” Economist Hyman Minsky’s “financial instability hypothesis” helps answer this question.

Classical Economics Assumes the Market Is Fundamentally Stable

An assumption underlying classical economic theory is that the economy is fundamentally stable and seeks equilibrium. The theory holds that as excesses occur, rational market actors see the excesses and act to make money or avoid losing it, and thereby move the economy back toward equilibrium.

According to this theory, bubbles and crashes are caused by external shocks to the economy such as disease, wars, and technological discoveries. While external shocks, such as the OPEC oil embargo of the 1970s or the current pandemic, certainly have significant economic effects, they don’t adequately explain the sequence of booms and busts that we have seen. The dotcom bust of 2000 and the financial crisis of 2008 weren’t caused by external shocks; they illustrate that the economy is not fundamentally stable.

Minsky Proposed that The Market Is Fundamentally Unstable

Hyman Minsky was an economist at Washington University in St. Louis from 1965 to 1990. He proposed a theory he labeled the financial instability hypothesis, which holds that the economy creates its own bubbles and crashes. The gist of his theory is that stable economies sow the seeds of their own destruction because stability, seeming safe, encourages people to take risks. That risk-taking creates financial instability that eventually results in panic and crisis.

Unfortunately, during his lifetime, neither Minsky nor his hypothesis was taken seriously. He died in 1996, before the dotcom bubble and the Great Recession, both of which gave credence to his ideas. His theory is now accepted as a primary explanation for the boom-and-bust cycles in the economy.

The financial instability hypothesis is rooted in swings between excessive risk-taking and the panic that follows when the risk-taking overheats and the economy collapses. Increased risk in the economy can be seen in the terms on which debt is incurred. Minsky hypothesized three stages of lending he dubbed hedge, speculative, and Ponzi.

During the hedge stage, lenders and borrowers are cautious because of the losses they incurred in the prior recession. Borrowers are wary of leverage, and lenders make loans in modest amounts with stringent credit requirements. During this stage, the amount of debt in the system is reasonable.

In the following speculative stage, market participants become more confident of a recovery. Borrowers take on greater amounts of debt, and the economy begins to boom. Lenders grant credit based on ever-lower standards, assuming that asset prices will continue to rise. During this stage, borrowers can cover the interest on the loans, but become less able to repay the principal.

By the final Ponzi stage, lenders and borrowers have forgotten the lessons of the prior crisis. Everyone is sure that asset prices will continue to rise, and debt is granted with repayments based on that assumption. The economy becomes over-leveraged; debt and risk-taking have created a financial house of cards.

Finally, a “Minsky Moment”—as the New Yorker dubbed it in 2008—occurs. Market insiders take profits, everyone panics, and a crash ensues before the cycle starts over.

The key insight of Minsky’s model is that stability itself is destabilizing (see figure below) because during times of economic stability, healthy investments lead to speculative euphoria, increasing financial leverage, and over-extending debt, eventually resulting in a Minsky Moment, which leads to a recession or even a financial crisis.

Minsky’s Cycle of The Economy

Paradoxically, Minsky’s hypothesis teaches us that the time of greatest investment risk is when everything seems good, and investing is actually least risky when, as Baron Rothschild once put it, there is “blood in the streets.”

How Minsky Can Help Us Be Better Investors

Minsky’s financial instability hypothesis is an essential mental model for us to have in our toolkit. Each cycle has its own characteristics and length. Euphoria and panic can both last longer than we might expect. And outside shocks such as a pandemic or geopolitical events can have big effects as well. So, we can’t predict with precision when the economy will transition from one part of the cycle to the next.

But knowing roughly where we are in the cycle can inform good strategies for investors and business owners. As the economy and markets move from boom to euphoria, it’s essential to have a healthy margin of safety in the form of cash and high-quality bonds. Smart businesses will increase their cash to shore up liquidity and resist the temptation to take on more debt. Then when the profit-taking and panic occur, they can redeploy their safety margin into bargain-priced risk assets.

The most important lesson to take from Minsky’s hypothesis is not to get caught up in the fear that comes with the panicky part of the cycle, or the greed that accompanies the euphoria. While it’s not possible to accurately time the tops and bottoms of the market, knowing roughly where we are in the cycle may help you stick with your investment strategy and avoid following the herd at full speed into a bust.

St. Louis Trust & Family Office is an independent, multi-family office and trust company that advises clients on more than $13 billion of investment assets and more than $15 billion of total wealth. Founded in 2002, St. Louis Trust & Family Office provides holistic, high-touch client service including customized, independent investment management and a full range of family office and fiduciary services. The firm serves a limited number of clients with substantial wealth in order to maintain very low client-to-employee ratios. Visit stlouistrust.com to explore how the firm manages complexity with unmatched expertise and focuses on Family, Always.

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Home » Investing » Trading Strategies » Debt Is Sowing the Seeds of the Next Crisis

Debt Is Sowing the Seeds of the Next Crisis

Posted by Ted Bauman | Feb 19, 2018 | Trading Strategies

4 minute, 51 second read

That innocuous surname has become my one-word rebuttal whenever someone suggests that we need not worry about financial markets.

It may be shorthand … but to those in the know, it’s terrifying.

It’s meant to be.

To me, “Minsky” is a reminder that long stretches of prosperity — such as the one we’ve been in since 2009 — sow the seeds of the next crisis.

Minsky’s hypothesis did something most mainstream economists don’t do: He included empirical evidence of human nature in his model.

By contrast, his peers — and policymakers — relied almost entirely on abstract models. And they thought the structure of the financial system was irrelevant.

Minsky argued that this was bunkum. In the real world, the level and type of debt in the economy drives major economic cycles. We ignore it at our peril.

Post-2008, economists have started to use the term “Minsky moment” to describe when credit markets begin to deleverage after an extended period of rising debt levels.

Knowing when a Minsky moment is in the horizon is critical … especially if you’re near or in retirement…

The Minsky Model

Minsky distinguished between three kinds of financing.

• The first is when households and firms rely on future cash flows to repay borrowings. It works fine as long as they have a manageable debt load and a steady income.
• The second financing strategy is riskier. Households and firms rely on cash flow to repay interest but must roll over their principal debt into new loans. Minsky called this “speculative” financing.
• Minsky’s third type of financing — which he called “Ponzi financing” — is the most dangerous. Cash flow covers neither principal nor interest. Households and firms bet that the value of their assets will appreciate by enough to cover their liabilities.

Economies with strong cash flows and low debt levels are stable. But economies based on speculative and, especially, Ponzi finance are vulnerable to sudden collapses.

If asset values start to fall, either because of monetary tightening or some external shock, overindebted households and firms are forced to liquidate their positions. This burst of selling further undermines asset values, making things worse. Things spiral out of control.

That’s a Minsky moment — like 2008, for example.

Obviously, the way to avoid Minsky moments is to stick to safe and sustainable financing.

But when the economy is humming, and interest rates are low, the temptation to take on debt is irresistible.

Households borrow. Firms borrow to repurchase shares, since that’s a quicker way to boost share values than actual investment. Obliging banks lower their credit standards as the boom period unfolds.

Debt levels grow to speculative and Ponzi levels. Boom becomes bust.

Minsky’s conclusion was that economic stability breeds instability. Periods of prosperity create financial fragility.

Everything is fine until it’s not.

How Minsky Are We?

Let’s look at some indicators of debt.

First, global debt, including public, private and corporate debt, has increased substantially since 2007. The main drivers are the U.S. and, especially, China:

Within that global debt, nonfinancial corporate debt grew by 15% from 2011 to 2017 — from 81% to 96% of global gross domestic product (GDP). The total debt burden of all global firms is now almost equal to the world’s annual economic output.

Moreover, the proportion of highly leveraged firms — those whose debt-to-earnings ratio exceeds 5 — was 37% in 2017, compared to 32% just before the global financial crisis.

Within the U.S., unsecured consumer debt has increased substantially since 2007, driven mainly by student debt. But total credit card debt today is about where it was then (red line below):

After declining until 2013, U.S. commercial and residential mortgage debt outstanding has resumed its steady march upward:

During the same time frame — roughly starting in 2013 — U.S. consumer debt repayment as a percentage of disposable income grew from under 5% to almost 6% today:

But here’s the one that worries me: Margin debt on brokerage accounts.

Margin debt is the mousetrap of the U.S. economy. It springs into action quickly, when equity values decline, and brokers call it in. Forced selling leads to a mini-Minsky moment in the stock market as sellers outnumber buyers.

It tends to peak just before big collapses — like the dot-com bust and the 2008 crisis. Its upward run since 2008 is quite spectacular:

Keep a Weather Eye for the Minsky Moment

Sailors like me know to keep a “weather eye.” Merriam-Webster defines it as “1: An eye quick to observe coming changes in the weather. 2: Constant and shrewd watchfulness and alertness.”

That sounds like very good advice right about now. Low interest rates have encouraged a lot of borrowing around the world. Consumers, firms and governments have taken advantage of these rates to try to recover ground lost since 2008.

But even though we’re in a so-called “coordinated global upswing,” forecast global GDP growth is still in the 2.5% to 2.8% range. That’s just not enough to generate the real economic income needed to pay down the gobs of debt hanging off the global economy — especially the two biggest players, the U.S. and China.

My advice: Enjoy the good times! But keep a good weather eye out for the next Minsky moment. And in the meantime, explore the many ways you can protect your wealth — before it comes.

Kind regards,

Editor, The Bauman Letter

Editor’s Note: Bitcoin has skyrocketed over the last few years … but the rally is puny compared to what’s ahead. There continues to be very positive evidence that the crypto bull market is just starting … and astute investors stand to make incredible gains in the months ahead. To learn the one simple secret to making a fortune from this new technology, click here now.

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Is Minsky’s financial instability hypothesis valid?

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Sébastien Charles, Is Minsky’s financial instability hypothesis valid?, Cambridge Journal of Economics , Volume 40, Issue 2, March 2016, Pages 427–436, https://doi.org/10.1093/cje/bev022

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In this article I reassess the validity of Minsky’s financial instability hypothesis and the main criticism about its internal coherence. Starting from this fundamental objection, I study Minsky’s contribution within the scope of a highly simplified macro-model. It is shown that the financial instability hypothesis (increasing debt ratios during economic expansion) remains valid in numerous cases. It appears, amongst other things, that a sufficient fall in the retention rate reinforces Minsky’s conclusions, emphasising the destabilising role of shareholders in the distribution of net profits.

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The Financial Instability Hypothesis

The Jerome Levy Economics Institute Working Paper No. 74

10 Pages Posted: 30 Jul 1999

Hyman P. Minsky

Affiliation not provided to ssrn (deceased).

Date Written: May 1992

The Financial Instability Hypothesis (FIH) has both empirical and theoretical aspects that challenge the classic precepts of Smith and Walras, who implied that the economy can be best understood by assuming that it is constantly an equilibrium-seeking and sustaining system. The theoretical argument of the FIH emerges from the characterization of the economy as a capitalist economy with extensive capital assets and a sophisticated financial system. In spite of the complexity of financial relations, the key determinant of system behavior remains the level of profits: the FIH incorporates a view in which aggregate demand determines profits. Hence, aggregate profits equal aggregate investment plus the government deficit. The FIH, therefore, considers the impact of debt on system behavior and also includes the manner in which debt is validated. Minsky identifies hedge, speculative, and Ponzi finance as distinct income-debt relations for economic units. He asserts that if hedge financing dominates, then the economy may well be an equilibrium-seeking and containing system: conversely, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a "deviation-amplifying" system. Thus, the FIH suggests that over periods of prolonged prosperity, capitalist economies tend to move from a financial structure dominated by hedge finance (stable) to a structure that increasingly emphasizes speculative and Ponzi finance (unstable). The FIH is a model of a capitalist economy that does not rely on exogenous shocks to generate business cycles of varying severity: business cycles of history are compounded out of (i) the internal dynamics of capitalist economies, and (ii) the system of interventions and regulations that are designed to keep the economy operating within reasonable bounds.

JEL Classification: E32

Suggested Citation: Suggested Citation

Hyman P. Minsky (Contact Author)

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What were some of the key economic ideas of Hyman Minsky?

Last updated 16 Jul 2023

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Hyman Minsky, an American economist, made significant contributions to our understanding of financial instability and the role of the financial sector in the economy.

Here are some of his key economic ideas:

• Financial Instability Hypothesis: Minsky's most influential idea is the Financial Instability Hypothesis. He argued that stability in the financial system leads to increased risk-taking behavior by economic agents, which eventually leads to financial instability and crises. Minsky described three stages of the financial cycle: the hedge stage (low risk-taking), the speculative stage (increased risk-taking), and the Ponzi stage (extreme risk-taking). According to Minsky, periods of prolonged stability create the conditions for a subsequent financial crisis.
• Instability in Capitalist Economies: Minsky challenged the prevailing belief that capitalist economies are inherently stable. He argued that financial instability is a characteristic feature of capitalist systems due to the nature of credit and debt relationships. Minsky emphasized that financial markets are prone to bouts of euphoria, speculative excesses, and subsequent busts.
• Financial Fragility and Debt Accumulation: Minsky highlighted the importance of debt accumulation and its role in driving financial instability. He argued that during periods of economic expansion, borrowers and lenders become increasingly optimistic and willing to take on more debt. However, as debt levels rise, the ability of borrowers to service their debt becomes more precarious, leading to a greater risk of defaults and financial crises.
• Role of Financial Institutions: Minsky emphasized the role of financial institutions, such as banks and shadow banks, in amplifying financial instability. He argued that financial institutions play a critical role in generating and spreading financial fragility through their lending and investment activities. Minsky highlighted the importance of proper regulation and oversight of financial institutions to mitigate the risks of instability.
• The Lender of Last Resort: Minsky advocated for the role of the lender of last resort, typically the central bank, in mitigating financial crises. He argued that in times of financial distress, the central bank should provide liquidity and act as a stabilizing force to prevent the widespread collapse of the financial system.
• Policy Implications: Minsky's work had implications for economic policy. He argued that policymakers should focus on managing financial instability and preventing the build-up of excessive debt. He emphasized the need for stricter financial regulation, including measures to curb speculative excesses and promote responsible lending practices.

Minsky's ideas have gained renewed attention, particularly following the global financial crisis of 2007-2008. His work has shaped the field of macroeconomics and financial economics, emphasizing the importance of understanding the dynamics of financial markets and the risks of financial instability in modern economies.

Here are some of his notable works:

• Stabilizing an Unstable Economy (1986): This book is a classic work on financial instability that describes the three phases of financial markets and the role of debt in financial instability.
• Can It Happen Again? (1982): This book is a collection of essays that discusses the causes of the Great Depression and the lessons that can be learned from it.
• The Financial Instability Hypothesis (1992): This paper is a seminal paper that outlines the financial instability hypothesis.

Minsky is a leading figure in the field of financial instability. His work has helped to explain the causes of financial crises, and he has argued for a more active role for the government in stabilizing the financial system. His work has also been influential in the field of public policy, and it has been used to justify government intervention in the financial system, such as financial regulation and lender of last resort facilities.

• Hyman Minsky
• Financial Instability Hypothesis
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• DOI: 10.2139/ssrn.161024
• Corpus ID: 154686540

The Financial Instability Hypothesis

• Published 1 May 1992
• Macroeconomics eJournal

1,156 Citations

Minsky’s financial instability hypothesis and the role of equity: the accounting behind hedge, speculative, and ponzi finance.

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Minsky’s moment

The second article in our series on seminal economic ideas looks at hyman minsky’s hypothesis that booms sow the seeds of busts.

FROM the start of his academic career in the 1950s until 1996, when he died, Hyman Minsky laboured in relative obscurity. His research about financial crises and their causes attracted a few devoted admirers but little mainstream attention: this newspaper cited him only once while he was alive, and it was but a brief mention. So it remained until 2007, when the subprime-mortgage crisis erupted in America. Suddenly, it seemed that everyone was turning to his writings as they tried to make sense of the mayhem. Brokers wrote notes to clients about the “Minsky moment” engulfing financial markets. Central bankers referred to his theories in their speeches. And he became a posthumous media star, with just about every major outlet giving column space and airtime to his ideas. The Economist has mentioned him in at least 30 articles since 2007.

If Minsky remained far from the limelight throughout his life, it is at least in part because his approach shunned academic conventions. He started his university education in mathematics but made little use of calculations when he shifted to economics, despite the discipline’s growing emphasis on quantitative methods. Instead, he pieced his views together in his essays, lectures and books, including one about John Maynard Keynes, the economist who most influenced his thinking. He also gained hands-on experience, serving on the board of Mark Twain Bank in St Louis, Missouri, where he taught.

Having grown up during the Depression, Minsky was minded to dwell on disaster. Over the years he came back to the same fundamental problem again and again. He wanted to understand why financial crises occurred. It was an unpopular focus. The dominant belief in the latter half of the 20th century was that markets were efficient. The prospect of a full-blown calamity in developed economies sounded far-fetched. There might be the occasional stockmarket bust or currency crash, but modern economies had, it seemed, vanquished their worst demons.

Against those certitudes, Minsky, an owlish man with a shock of grey hair, developed his “financial-instability hypothesis”. It is an examination of how long stretches of prosperity sow the seeds of the next crisis, an important lens for understanding the tumult of the past decade. But the history of the hypothesis itself is just as important. Its trajectory from the margins of academia to a subject of mainstream debate shows how the study of economics is adapting to a much-changed reality since the global financial crisis.

Minsky started with an explanation of investment. It is, in essence, an exchange of money today for money tomorrow. A firm pays now for the construction of a factory; profits from running the facility will, all going well, translate into money for it in coming years. Put crudely, money today can come from one of two sources: the firm’s own cash or that of others (for example, if the firm borrows from a bank). The balance between the two is the key question for the financial system.

Minsky distinguished between three kinds of financing. The first, which he called “hedge financing”, is the safest: firms rely on their future cashflow to repay all their borrowings. For this to work, they need to have very limited borrowings and healthy profits. The second, speculative financing, is a bit riskier: firms rely on their cashflow to repay the interest on their borrowings but must roll over their debt to repay the principal. This should be manageable as long as the economy functions smoothly, but a downturn could cause distress. The third, Ponzi financing, is the most dangerous. Cashflow covers neither principal nor interest; firms are betting only that the underlying asset will appreciate by enough to cover their liabilities. If that fails to happen, they will be left exposed.

Economies dominated by hedge financing—that is, those with strong cashflows and low debt levels—are the most stable. When speculative and, especially, Ponzi financing come to the fore, financial systems are more vulnerable. If asset values start to fall, either because of monetary tightening or some external shock, the most overstretched firms will be forced to sell their positions. This further undermines asset values, causing pain for even more firms. They could avoid this trouble by restricting themselves to hedge financing. But over time, particularly when the economy is in fine fettle, the temptation to take on debt is irresistible. When growth looks assured, why not borrow more? Banks add to the dynamic, lowering their credit standards the longer booms last. If defaults are minimal, why not lend more? Minsky’s conclusion was unsettling. Economic stability breeds instability. Periods of prosperity give way to financial fragility.

With overleveraged banks and no-money-down mortgages still fresh in the mind after the global financial crisis, Minsky’s insight might sound obvious. Of course, debt and finance matter. But for decades the study of economics paid little heed to the former and relegated the latter to a sub-discipline, not an essential element in broader theories. Minsky was a maverick. He challenged both the Keynesian backbone of macroeconomics and a prevailing belief in efficient markets.

It is perhaps odd to describe his ideas as a critique of Keynesian doctrine when Minsky himself idolised Keynes. But he believed that the doctrine had strayed too far from Keynes’s own ideas. Economists had created models to put Keynes’s words to work in explaining the economy. None is better known than the IS-LM model, largely developed by John Hicks and Alvin Hansen, which shows the relationship between investment and money. It remains a potent tool for teaching and for policy analysis. But Messrs Hicks and Hansen largely left the financial sector out of the picture, even though Keynes was keenly aware of the importance of markets. To Minsky, this was an “unfair and naive representation of Keynes’s subtle and sophisticated views”. Minsky’s financial-instability hypothesis helped fill in the holes.

His challenge to the prophets of efficient markets was even more acute. Eugene Fama and Robert Lucas, among others, persuaded most of academia and policymaking circles that markets tended towards equilibrium as people digested all available information. The structure of the financial system was treated as almost irrelevant. In recent years, behavioural economists have attacked one plank of efficient-market theory: people, far from being rational actors who maximise their gains, are often clueless about what they want and make the wrong decisions. But years earlier Minsky had attacked another: deep-seated forces in financial systems propel them towards trouble, he argued, with stability only ever a fleeting illusion.

Yet as an outsider in the sometimes cloistered world of economics, Minsky’s influence was, until recently, limited. Investors were faster than professors to latch onto his views. More than anyone else it was Paul McCulley of PIMCO, a fund-management group, who popularised his ideas. He coined the term “Minsky moment” to describe a situation when debt levels reach breaking-point and asset prices across the board start plunging. Mr McCulley initially used the term in explaining the Russian financial crisis of 1998. Since the global turmoil of 2008, it has become ubiquitous. For investment analysts and fund managers, a “Minsky moment” is now virtually synonymous with a financial crisis.

Minsky’s writing about debt and the dangers in financial innovation had the great virtue of according with experience. But this virtue also points to what some might see as a shortcoming. In trying to paint a more nuanced picture of the economy, he relinquished some of the potency of elegant models. That was fine as far as he was concerned; he argued that generalisable theories were bunkum. He wanted to explain specific situations, not economics in general. He saw the financial-instability hypothesis as relevant to the case of advanced capitalist economies with deep, sophisticated markets. It was not meant to be relevant in all scenarios. These days, for example, it is fashionable to ask whether China is on the brink of a Minsky moment after its alarming debt growth of the past decade. Yet a country in transition from socialism to a market economy and with an immature financial system is not what Minsky had in mind.

Shunning the power of equations and models had its costs. It contributed to Minsky’s isolation from mainstream theories. Economists did not entirely ignore debt, even if they studied it only sparingly. Some, such as Nobuhiro Kiyotaki and Ben Bernanke, who would later become chairman of the Federal Reserve, looked at how credit could amplify business cycles. Minsky’s work might have complemented theirs, but they did not refer to it. It was as if it barely existed.

Since Minsky’s death, others have started to correct the oversight, grafting his theories onto general models. The Levy Economics Institute of Bard College in New York, where he finished his career (it still holds an annual conference in his honour), has published work that incorporates his ideas in calculations. One Levy paper, published in 2000, developed a Minsky-inspired model linking investment and cashflow. A 2005 paper for the Bank for International Settlements, a forum for central banks, drew on Minsky in building a model of how people assess their assets after making losses. In 2010 Paul Krugman, a Nobel prize-winning economist who is best known these days as a New York Times columnist, co-authored a paper that included the concept of a “Minsky moment” to model the impact of deleveraging on the economy. Some researchers are also starting to test just how accurate Minsky’s insights really were: a 2014 discussion paper for the Bank of Finland looked at debt-to-cashflow ratios, finding them to be a useful indicator of systemic risk.

Debtor’s prism

Still, it would be a stretch to expect the financial-instability hypothesis to become a new foundation for economic theory. Minsky’s legacy has more to do with focusing on the right things than correctly structuring quantifiable models. It is enough to observe that debt and financial instability, his main preoccupations, have become some of the principal topics of inquiry for economists today. A new version of the “Handbook of Macroeconomics”, an influential survey that was first published in 1999, is in the works. This time, it will make linkages between finance and economic activity a major component, with at least two articles citing Minsky. As Mr Krugman has quipped: “We are all Minskyites now.”

Central bankers seem to agree. In a speech in 2009, before she became head of the Federal Reserve, Janet Yellen said Minsky’s work had “become required reading”. In a 2013 speech, made while he was governor of the Bank of England, Mervyn King agreed with Minsky’s view that stability in credit markets leads to exuberance and eventually to instability. Mark Carney, Lord King’s successor, has referred to Minsky moments on at least two occasions.

Will the moment last? Minsky’s own theory suggests it will eventually peter out. Economic growth is still shaky and the scars of the global financial crisis visible. In the Minskyan trajectory, this is when firms and banks are at their most cautious, wary of repeating past mistakes and determined to fortify their balance-sheets. But in time, memories of the 2008 turmoil will dim. Firms will again race to expand, banks to fund them and regulators to loosen constraints. The warnings of Minsky will fade away. The further we move on from the last crisis, the less we want to hear from those who see another one coming.

LATER IN THIS SERIES: • The Stolper-Samuelson theorem • The Keynesian multiplier • The Nash equilibrium • The Mundell-Fleming trilemma

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