Hyman Minsky: A Visionary Economist

Introduction

This paper explores the theories of Hyman Minsky concerning financial instability in capitalist economies, characterized as Financial Keynesianism, and then reviews the recommendations of Minsky to regulate this financial instability and emphasizes how relevant his analyses remain to comprehending current economic crises. Understanding the crucial role that finance plays in the economy is necessary to gain a sound economic interpretation of the world. Minsky understood that in an increasingly financialized world, mainstream economics, based on mathematical models, fails to produce the proper diagnostics as it ignores the importance of uncertainty and human behaviour. In times of great uncertainty and crisis (such as pandemics, war, and climate change), the work of Minsky continues to act as a guide.

This paper starts by introducing the context in which Minsky created the theory of financial instability. Built as an alternative to the dominant neo-classical theory, the Financial Instability Hypothesis (FIH) arose from his interpretation of Keynes. The paper goes on to explore his explanations of instability in financialized economies, emphasizing the influence of Schumpeter on his analyses. Eventually, the paper turns to the policy suggestions of Minsky, insisting on the role he gave to state intervention, to then focus on the applicability of his theories in understanding modern financial and economic challenges, such as the Great Recession of 2007-08.

The Financial Instability Hypothesis: an Answer to the Need for Theory

Following a post-war period marked by the strong influence of Keynesian approaches, the 1980s marked the great victory of neo-classical theories in economic thought. These theories dominated the academic world but also the advisory and policy-making circles, where they morphed into an indisputable doctrine. Neoclassical economists, guided by their belief in the analytical assumptions made by the Walrasian General Equilibrium theory, assumed that the equilibrium-seeking and sustaining result achieved by the Walrasian auction described decentralized market processes. That is, they were convinced of the inherent stability of this type of economy.

In true Keynesian fashion, Hyman Minsky believed the fundamental purpose of economics to be solving practical problems rather than abstract mathematical models. Therefore, he considered neo-classical theories to be incapable of grasping the complexities and interdependencies of the real-world economy, especially one with money and sophisticated financial institutions (Wray, 2016). The twenty years following World War II (1945-65) were a period of relative tranquillity for the US economy, but the “credit crunch” of 1966 and two other similar episodes brought back the spectre of financial threat. While neoclassical economists saw these threats as anomalies, Minsky was convinced that they were systemic. For him, the robustness of government and financial structures, especially the intervention of the Federal Reserve as a lender of last resort, was the only reason the economy avoided deep depressions after World War II. Despite these alarming signs, boosted by blind neo-classical diagnostics, policy incentives (particularly in the US) aimed at shrinking government intervention surged (Whalen, 2001). Concerned by the rising fragility of financial markets caused by financial actors’ profit-seeking activities, Minsky sought to develop an alternative theory that could explain the inherent instability of financially sophisticated capitalist economies.

Aware of the difficulty of developing new theories, Minsky sought to make the task more accessible by "standing on the shoulders of giants" (Minsky, 1977, p. 26). As such, he built his Financial Instability Hypothesis (FIH) by making considerable use of John Maynard Keynes' work. His interpretation of Keynes diverged from the standard Hicksian neoclassical synthesis of the General Theory, which, in his view, failed to grasp the contribution of Keynes to economic theory. In this sense, Minsky should be characterized as a "financial Keynesian" (Caverzasi, 2014), similar to post-Keynesians but radically different from neo-Keynesian economists (Lavoie, 2020). In the opinion of Minsky, the core of the Keynesian vision is best understood in the rebuttal of Keynes to Jacob Viner for his review of the General Theory. The response of Keynes was published in the Quarterly Journal of Economics (QJE) in 1937. In this, Keynes focuses on the link between investment decisions and the forces that drive financial market instability. Therefore, according to Minsky, the General Theory is mainly concerned with what Keynes explores in the QJE article: how the valuation of assets and the price of current output and wages interact to determine the investment pace, which Keynes argues is the critical determinant of aggregate activity (Keynes, 1937). Minsky asserts that Keynes can explain the fluctuations of capitalist economies because of how he models these economies. Unlike the neoclassical approach, which models the economy as a "village fair" in which bartering takes place and where money only serves a transactional purpose, Keynes adopts what Minsky names the "Wall Street Paradigm."

In this model, "The economy is viewed from the board room of a Wall Street investment bank," (Minsky, 1977, p. 21). Indeed, the Keynesian theory starts by assuming an economy with sophisticated financial institutions where money is more than a simple transaction tool — it is a particular type of bond. In this economy, agents borrow money to invest in capital assets. Therefore, the owners of real wealth possess money, not real assets.

For Minsky, this conception of money as a "financing veil" between the real asset and the wealth owner is crucial to understanding Keynes' approach and capitalist economies. Indeed, Keynes identifies financial variables as the key source of instability in capitalist economies. He claimed that since investment decisions are taken in the face of uncertainty, whenever expectations about the future change, the valuation of capital assets and access to credit, suffer sudden and violent movements. This, in turn, affects the pace of investment.

Following Keynesian thought by developing and applying a "Wall Street Paradigm" to explore the contemporary form of capitalism, Minsky characterizes the US capitalist economy of his time as a "paper world." In this world, most business deals rely on paper commitments to pay cash in the future in exchange for cash today. Minsky claims that economic stability depends on the cash flows, or gross profits, generated by the actors of this economy. He shows that in order for firms to validate their debts and have access to funds, they must be expected to generate sufficient gross profits in the future to cover their required debt payments. These profit flows are determined by the relative scarcity of capital assets used in production, which is determined by the pace of investment. Therefore, since access to financing is indirectly dependent on investment pace, the present liability–debt structures accepted by banks reflect the current state of speculation about future investment (Minsky, 1977). This loop reasoning is synthesized in the following diagram:

Since the behavior of this "paper world" is dependent on the pace of investment, gross profits play a crucial role. First, they constitute the funds available for debts to get validated (1), allowing firms to invest in capital assets. Second, they play a role through the excess of gross profits accruing to equity shareholders (2), which then determines equity share prices and, thus, the market valuation of capital assets. Eventually, these asset valuations and market conditions drive investment demand (3). It is important to emphasize that the ability to finance new investments through debt depends heavily on the expectations that future returns from said investment will be high enough to produce sufficient cash flows for debt repayment. According to Minsky, the subjectivity of these investment expectations and the bankers' determination of the appropriate liability structures explains why such a financialized economy is unstable.

Minsky distinguishes three types of financial positions in this economy: hedge, speculative and Ponzi units. Hedge units are firms with expected cash flows exceeding their financial commitments, which means they can repay their debt without risk. Speculative units generate enough inflows to repay interest but not the outstanding principal on the debt, so the debtor needs to roll over the debt – borrow more money to make the principal repayments. Finally, Ponzi units need to borrow additional money or sell assets as their cash inflows are insufficient to cover interest payments (Caverzasi, 2014).

Financial Innovations and the Upward Instability of Capitalism

Once the structure of the economy and the behavior of its actors have been described, Minsky analyzes how financial crises arise. In his view, the ideal environment for a crisis to find its roots is a stable, post-recession economy. Simply put, stability creates instability (Wray, 2016). Just after a recession, bankers are highly risk averse. This is reflected in their liability structures which are based on essential margins of safety in order to ensure that borrowers can repay their debts. In this initial post-recession period, most of the financial units in the economy are hedge units. As the economy recovers and firms become increasingly profitable, banks, investment bankers, and businessmen notice two things: existing debts are easily validated, and, since debt is easily available, investment returns across the board are increased by the leverage effect; The leverage effect is such that profit margins are magnified by increasing debt levels. Higher leverage essentially allows a firm to invest beyond its current means for a higher return. Consequently, after a period of strong economic growth, the views on acceptable liability structures change. As banks become more optimistic, they allow borrowers to use greater debt levels to finance their investments. The economy-wide increase in the proportion of debt financing eases access to funds and raises the market valuation of capital assets, further boosting investment. Because of this self-reinforcing process, the economy enters a boom where speculative and Ponzi units progressively replace hedge units. As a result of this process, Minsky concludes that the fundamental instability of a capitalist economy is upward: it lies in this tendency to "transform doing well into a speculative investment boom" (Minsky, 1977, p. 24).

Joseph Schumpeter perceived commercial bankers to be the "ephors" of capitalism. Indeed, he considered financial innovations to be the ultimate cause of booms and busts in capitalist economies. Following Schumpeter, who had been his dissertation advisor, Minsky shows that speculative practices are validated by the activity of banks, which is a crucial factor in guiding the economy toward an unsustainable path. Minsky describes banks as innovative agents, able to expand credit — with a given amount of reserves — by using financial innovations to overcome limitations imposed by financial authorities (Papadimitriou & Wray, 2010). By stretching the amount of financing available, these experimental innovations of debt structures reinforce the speculation on capital assets. When things start to go wrong and payment defaults increase, sudden changes in expectations spark a movement of general panic, causing the burst of the speculative bubble and initiating a financial crash. Therefore, Minsky argues that through financial innovations, capitalist economies endogenously generate the financial structures necessary for financial crises to occur.

The Subprime Crisis and the Crucial Need for Market Regulation

According to Minsky, when the economy is on the brink of a crisis, Federal Reserve intervention is required to avoid debt deflation. The three premises of financial crises in the 1960-1970 decade in the US have shown that the decline in investment caused by the contraction of debt financing induces a reduction in income. Therefore, if we go back to our synthesized representation of the economy, massive government spending and the resulting deficits are required to counteract this drop in income (see 5 in the figure). These deficits will sustain income and increase corporate profits, allowing debt validations to return to a stable level. Even if the economy recovers from the recession, there are side effects. The Federal Reserve intervention protected various financial markets through expansionary monetary policy. A byproduct of recovery achieved through such policy is the risk of triggering inflationary pressures. Perfect policies surely do not exist, but the analysis of Minsky shows us that the evolution of capitalism is deeply rooted in its financial structures (Whalen, 2001). Therefore, making speculative activities unconstrained is extremely dangerous.

In hindsight, there is a lot of truth to what Minsky has to say. His FIH is highly relevant to understanding the subprime crisis of 2007. Whether one could characterize this crisis as a “Minsky moment” is debatable. Indeed, the presence of Ponzi schemes in the subprime mortgage markets was not the result of endogenous forces, as in the Minsky FIH framework, but rather due to structural changes in the financial system, which made banks careless in their evaluation of credit risk (Kregel, 2008).

Nevertheless, the analytical framework of Minsky remains extremely useful in understanding how an economy can crash by endogenously overcoming its regulatory limits. As emphasized in the FIH framework, the years preceding the subprime crisis were marked by banks displaying excessive innovative behavior. The proliferation of new financial instruments stimulated credit expansion and reduced safety margins as banks spread the risk. The first innovation consisted of bundling mortgages – considered safe – into mortgage-backed securities (MBS) securities, which would provide periodic payments similar to coupon bonds. These were then grouped into different tranches of risky MBS securities for the creation of collateralized debt obligations (CDOs). The lowest tranches of CDOs were made up of extremely risky MBS securities products. These risky tranches were packaged together with less risky tranches into CDOs in such a way that the final product would receive safe ratings comparable to government bonds. Finally, the creation of credit default swaps (CDS), allowing banks to get insured in case of defaults, made them blind to the risk of insolvency on the debt they issued. Progressively, households investing in the housing market with debt saw their positions becoming fragile until the number of speculative and Ponzi households became unsustainable (Caverzasi, 2014).

The analysis of Minsky is not perfectly compatible with the explanation of the 2007 crisis because capitalism evolved greatly between his death, in 1996, and 2007. Nevertheless, his work still catches some essential destabilizing features of modern capitalism and will continue to guide us in the future.

By Alessandro Bozzi for ECON 461: History of Thought II

Edited by Sehrish Ahmed, Viktor Biquet, & Romain Perusat

References

Caverzasi, E. (2014) Minsky and the Subprime Mortgage Crisis: The Financial Instability Hypothesis in the Era of Financialization. Levy Economics Institute of Bard College, 796.

Keynes, J.M. (1937) The General Theory of Employment. Quarterly Journal of Economics, 51(2), 209-223.

Kregel, J. (2008) Minsky’s Cushions of Safety: Systemic Risk and the Crisis in the U.S Subprime Mortgage Market, Economics Public Policy Brief, 93.

Lavoie, M. (2020) Was Hyman Minsky a post-Keynesian economist?. Review of Evolutionary Political Economy, 1, 85–101.

Minsky, H.P (1977) The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to “Standard” Theory. Challenge, 20(1), 20-27.

Papadimitriou, D.B. & Wray, L. (2010) Introduction: Minsky on money, banking and finance. The Elgar companion to Hyman Minsky.

Whalen, C.J (2001) Integrating Schumpeter and Keynes: Hyman Minsky’s Theory of Capitalist Development, Journal of Economic Issues, 35(4), 805-823.

Wray, L. R. (2016) Why Minsky matters: an introduction to the work of a maverick economist. Princeton: Princeton University Press.