Financial Instability

The Financial Instability Hypothesis of Hyman Minsky suggests that free markets have an inherent tendency to excesses.

Events of the last decade brought Minsky’s theory to the front.

“Markets” play a role, but who are the real actors in this area?  What about government fiscal policy, Central bankers, hedge funds or others?

Do Insurers & Pension funds play a role?

Finally, are there ways to moderate the valuation cycles?

Can regulators and central banks take counter cyclical actions?  If so, what would they be?

In the insurance and banking world, are capital requirements pro-cyclical?  If so, how could they be modified to be counter cyclical?  What would the the other consequences of such changes?


5 Comments on “Financial Instability”

  1. […] understand leverage better. Look at the Minsky Financial Instability Model myself. Often, we are not honest with ourselves on the extent of debt. RISKVIEWS favors full […]

  2. riskviews Says:

    I just finished reading a book entitled “The Origin of Financial Crises” by George Cooper. I would recommend this book.

    Cooper gives a very clear discussion of how Hyman Minsky’s Financial Instability Theory has applied to the current situation. (I have read some of Minsky’s work – Cooper does a better job of explaining – but then Minsky’s works were written for economists.)

    Here are some key points from his book:

    1. Asset/debt markets are not equilibrium seeking like markets for goods and services. That is because there is a feedback loop involved in asset/debt markets. When an asset increases in value, wealth increases. The increased value can be used for collateral for more borrowing that increases money supply and increases demand for the asset, which further increases prices. (Same thing happens in reverse with decreases in asset prices.)

    2. Asset value increases will also drive activity in the “real” economy to the extent that some of the increase in asset values bleeds into other spending (as was mentioned frequently in the housing run up). Increase in money available stimulates spending which creates profits which stimulates more investment. When the asset values reverse, this process sucks up money dampening economic activity. Overinvestment means overcapacity because of distortion in the understanding of demand.

    3. Economists believe in equilibrium. And that markets – including asset/debt markets – are efficient. THerefore they do not believe that it is possible to identify a bubble until it has popped. [This in my opinion makes economists unsuited to be regulators]

    4. Economists have believed that economy can be helped after a bubble is popped by open market and fiscal actions. This one sided approach to regulation (never stop bubbles – always help after bubble pops) has had major negative – moral hazard.

    5. He suggests that policy for relieving bubbles needs to be two sided. The tactics for implementing this policy should be developed based upon the ideas of James Maxwell around the physical governor systems for machines. That work suggests that large interventions in a system are likely to be destabilizing. But that a series of small carefully determined interventions are able to create a desired correction to a system over time. (see On Governors, James Maxwell )

    An example of the feedback loop can be seen in the Oil price bubble of last year.

    You can also see that it did not create a systemic problem. That is because the amount of assets involved were not large enough.

    The housing market is large enough that a bubble there of 50% of value was more than enough to wipe out much of the financial system’s capital when the bubble popped.

    So the idea of the Systemic Risk Regulator would be to make sure that asset bubbles of assets that are held by the financial system do not get large as a percentage of the system’s capital.

    So I belive that size of the bubble is really the systematic concern.

    The internet bubble was also very large, but the assets were not held by the financial system.

  3. riskviews Says:

    Discussions of Minsky:

    Minsky, Austrians and the MMT

    Destabilizing Stability of the Greenspan Era
    Slides from a 2005 speech that nails what has emerged since that time. About 1/3 of the speech cites Minsky thinking as the argument that explains the problem.

    Click to access EdwardChancellorDestabizing.pdf

  4. riskviews Says:

    “Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on ‘income account’ on their liabilities, even as they cannot repay the principal out of income cash flows. Such units need to ‘roll over’ their liabilities – issue new debt to meet commitments on maturing debt. For Ponzi units, the cash flows from operations are not sufficient to fill either the repayment of principal or the interest 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 stocks lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes.

    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. 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. 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 system to financial relations that make for an unstable system.

    In particular, over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make positions by selling out positions. This is likely to lead to a collapse of asset values.”

    Minsky summarizes a part of his theory

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