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The Financial Instability Hypothesis & The 2007–2008 Financial Crisis.
What is the financial instability hypothesis of Hyman Minsky? It is a theory of the business cycle, a theory where he describes “the readily observed empirical aspect is that, from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control” (1). In his paper “The Financial Instability Crisis”, Minsky uses a framework that is based on a theory of the economy not with the Knightian version where the purpose of the economy is based on an allocation of resources, but the Minsky model of the economy is one where the economy exists in time as a developer of capital, one where there is an exchange of present money for future money (2). For Minsky in his model, the ownership of capital is a claim on money, not of real assets themselves: “in a capitalist economy the past, the present, and the future are linked not only by capital assets and labor force characteristics but also by financial relations” (4). This is an economy not as a snapshot, but as part of a process in time. Investment happens, Minsky claims, because businessmen expect investment to continue to happen in the future (6). The animal spirits are alive on the ground.
The core relationship of the financial instability hypothesis is based around this debt relationship. Banks act not only as middlemen. Firms are not just trading with other productive firms, but there is a model where the financial sector is a profit-seeking entity itself, and these “merchants of debt” (6) do what they can to innovate the products they sell.
Minsky described three different kinds of debt relationships as time passes. The first is “Hedge Financing,” where the debt can be paid by the borrowers with working cash flows. This is the most sustainable model. Firms borrow and they can pay off their debt easily with the money they get in the bank from operations. The second debt relationship is what he called “Speculative Finance.” In this relationship, the borrower is a little more stretched. They can afford to pay the interest, but the only the interest is paid out of cash flows, but the principle is not paid down. Net debt for the firm therefore does not decrease but stays constant. Finally, in the third form we reach what Minsky identifies as “Ponzi” units. If a borrower is in this…
