Economics brief: Financial stability: 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.