Minsky’s Financial Instability Hypothesis

Read this article to learn about the essence, origin and evaluation of Minsky’s financial instability hypothesis.

Essence of Minsky’s Financial Instability Hypothesis:

The main purpose of the conventional economic theory has been to show that the market economy is self-regulating and there is little need for any kind of intervention by the government.

This has been the purpose of economic theory ever since Adam Smith gave the first systematic exposition. Today, this is given a central place in the general equilibrium theory by modern economists.

In contrast, Post- Keynesians are unwilling to assume that market economy is self-regulating and they believe that active government intervention is necessary to avoid business fluctuations.

Prices, according to Post-Keynesians cannot be corrected because markets are likely to be destabilizing as stabilizing. Hence, the need for economic policies by the government and their intervention for active management of the economy. Therefore, Hyman Minsky criticized ‘neo-classical synthesis’ and develops a novel theory of the working of capitalist economies.

In his view, the financial structures and interrelations which are essential to the capitalist system inevitably result in the violent fluctuations of the economy. The financial aspects of advanced capitalism, which depend upon expectations, future profitability affect investment decisions, far from reinforcing equilibrating market mechanism, necessarily causing the system to be unstable. Minsky’s financial instability hypothesis, in essence, is that certain financial aspects of the capitalist economy, which are inseparable from its capitalist nature, make such an economy inherently unstable.

Prof. H. Minsky of Washington University has developed a theoretical model which constitutes an important characteristic of Post-Keynesian economics. This is his ‘Financial Instability’ explanation for the systematic instability of contemporary market capitalism. Prof. Minsky’s starting point is the basic argument of Keynes used in his General Theory that the economy is characterized by both persistent unemployment and persistent instability. The latter is systematic; not the result of random, external shocks. It is this aspect of the General Theory that was lost when the neoclassical synthesis emerged as a major school of macroeconomics after Second World War.

The neoclassical synthesis forced the Keynesian revolution back into the classical mold by showing that, in the absence of rigidities in either wages or prices (or both), the system is finally self-correcting and, given sufficient time, it will reach a full employment equilibrium. Thus, the neoclassical synthesis denies that the Keynesian revolution was a revolution in theory. Keynes, it has been said, may have won the policy war but did not win the theoretical war.

Origin:

This viewpoint is rejected by Minsky because the neoclassical synthesis ignores the importance that Keynes in the General Theory gave to financial factors in explaining how an economy based on market capitalism works. In Keynes theory, fluctuations in investment spending are the primary cause of economic instability. Prof. Minsky says that the crucial elements that account for chronic instability of investment spending are neglected.

These are the dis-equilibrating forces at work in the economy’s financial markets. Such forces affect primarily the valuation—that is, present value or demand price— of capital assets relating to the cost (or supply price) for newly produced capital. In the General Theory Keynes pointed out that the demand for liquidity and money are the basic sources of financial instability, the major elements round which the financial forces operate.

Today the economy is far more complicated because the financial system includes greater variety of financial instruments than originally mentioned by Keynes. It is this complexity and sophistication of the financial system that must be taken into account if we are to gain a proper understanding how investment decisions are actually made in the real world of market capitalism.

The main problem with standard economic theory—specially the neo-classical synthesis—is that it starts from what Minsky calls a ‘village fair’ perspective. This means that economic analysis starts with the idea of barter, as contained in Say’s Law, and then proceeds to elaborate on the basic process of exchange by adding production, capital goods, money and financial assets to the process. What is wrong with the ‘village fair’ approach is that it cannot explain why there are periodic disruptions to the process—why, in other words, we have the business cycles?

According to Prof. Minsky the proper starting point for understanding the economy’s behaviour is what he calls”—’Wall Street’ approach—a world dominated by commitments to obtain cash today and pay cash in the future. It is a world in which the distinction between ‘making goods’ and ‘making money’ has great relevance. In a world of ‘Wall Street’—the investment process flows from money to real investment to money, not from investment to money to consumption, as in the classical view. In other words, the cash flows which are the basis of ‘Wall Street’ approach have two dimensions.

First, cash obtained today is exchanged for the expectation of getting cash in future. This is what happens when investment takes place. Secondly, a cash obtained today is also exchanged for a promise to pay cash in the future. This is what happens when borrowing takes place in order to finance investment. The strength of the paper world of ‘ Wall Street’ rests upon the cash flow for business firms, households and governments received through the income generating process.

Income in the form of profits, wages, salaries and taxes generates a cash flow that sustain the commitments to repay debts contracted in the past. Unlike the classical world, in which money is a medium of exchange and has no effect upon the real exchange economy—in the paper world of ‘Wall Street’ developments that centre around debt, finance and cash flows are the ‘tail’ which frequently wags the ‘dog’ of output and employment.

Therefore, the key to the process of understanding is how the liability structures of firms, banks and other financial institutions evolve overtime and the manner in which this affects investment spending—the key to the fluctuations in private market economy. In the modern capitalist economy there is an enormous variety of both assets and liabilities that yield future income or incur future payments obligations.

Assets are acquired by the creation of financial liabilities taking various forms like shares and different forms of debts. Unless an economic unit (business firms and households) finance its investment expenditures wholly from internal sources—retained earnings, in other words— what “buys” real capital for the unit in a system of market capitalism is a stream of commitments the unit incurs for making future payments. According to Prof. Minsky the possession of money (or liquidity in general) acts as a kind of insurance against the economy’s mal-performance—the possession of money, in other words, is a cushion against adversity.

Evaluation:

Two sets of institutions like the ‘pricing institutions’ and the ‘financial institutions’ control the terms upon which the portfolio decisions and positions in assets are financed. In capitalist economy two types of relative prices are important, one relating to the production and distribution of output and the other to capital assets. Prices of financial institutions which are crucial to the investment decisions and understanding of the basic instability of the economic system are more important today. The liabilities of financial institutions usually involve a commitment to pay cash on demand, as is the case with the demand deposit.

Financial institutions differ from ordinary business firms in that the latter takes positions in real capital assets for which they issue liabilities—that is, debt—whereas the financial institutions take positions in financial rather than real assets. Whenever liabilities are issued to finance positions in assets, both financial and real—future cash-payment commitments are created.

According to Prof. Minsky the firm in accepting a liability structure in order to hold assets is betting that the real situation at future dates will be such that the cash payments commitments can be met; it is estimating that the odds in an uncertain future are favourable. Decisions made in this manner rest upon some margin of safety. This margin of safety lies in the excess of the firms receipts and holding of liquidity assets over its payment commitments; and whenever the margin of safety declines, the firm is in financial trouble.

Two broad conclusions emerge from Prof. Minsky’s financial instability hypothesis. Firstly, our system of market capitalism, is inherently unstable because the forces that cause periodic finance, output and debt crises are rooted in the system’s structure. This does not mean that capitalism should be rejected, according to Minsky, but it does show the little importance given to institutions and if we want to see the economy in the right perspective the importance of institutions must be given proper place and the economy must be allowed to be managed.

Secondly, according to Minsky there should be basic change in practical policies. Minsky feels investment is the source of instability, on account of the periodic need to bail out threatened financial structures (by central banks of the countries) is one of the major causes of inflation. Both instability and inflation may be controlled if the economy is oriented towards production of consumer goods through the techniques of less capital intensive nature than those which are now in use.

Policy, in other words, should be directed towards growth through consumption rather than through investment as has been the case since the 1970s. The financial instability hypothesis also suggests that while there are better ways of running the economy, there is no economic organisation or magic formula which, once achieved and set in motion, solves the problems of economic policy for all times. According to Minsky economists can never become economic engineers or technicians applying a once for all agreed upon theory that is fit for all seasons within an institutional structure that does not and need not change.

From the perspective of the financial instability hypothesis, inflation is one way to ease payment commitments due to debt. In the 1970s a big depression had been avoided by floating off untenable debt structures through inflation. Stagflation is a substitute for a big depression. Given that instability and inflation are due to the emphasis upon investment, transfer payments and the need to bail out the threatened financial structure, the financial instability hypothesis only shows that the economy which is oriented towards production of consumer goods will be liable to less inflation and financial instability.

This shows that the policy emphasis should shift from the encouragement of growth through investment to the attaining of full employment through consumption production. The financial instability hypothesis suggests that a simplification of financial structure, though difficult to achieve, is a better way of attaining greater stability in the economy. Hence, Minsky’s emphasis on institutions, especially money institutions and consumption can be described as a significant continuation to Post-Keynesian Economics.