Top: Getting Money Right

The Minsky Moment

Stanley Dundee

2019-12-25 v. 2

2017-09-05 v. 1

The Minsky Moment is that magical instant in a market when fear supplants greed, engendering the transition from boom to bust. Minsky persuasively argued that capital markets contain within themselves the basis for those breakdowns, in the gradual transition (associated most particularly with forgetting) from conservative, hedged financing, to riskier speculative financing, to, finally, unsustainable Ponzi financing. Minsky's Financial Instability Hypothesis is one of the most significant advances of 20th century economics.

Minsky's seminal work was reissued in 2008 by the Levy Institute in recognition of the relevance of his prescient analysis to the mortgage meltdown of 2007. From the blurb for Stabilizing an Unstable Economy:

Minsky insisted that there is an inherent and fundamental instability in our sort of economy that tends toward a speculative boom. Unlike other critical analyses of capitalist processes, which emphasize the crash, Minsky was more concerned with the behavior of agents during the euphoric periods. And unlike other analyses that blame shocks, irrational exuberance, or foolish policy, he argued that the processes that generate financial fragility are natural, or endogenous to the system.

Perry Mehrling provides a very useful explication of Minsky's financial instability hypothesis. Merling describes the evolving degree of mismatch between financing and cash flows as the cycle progresses:

At the very center of Minsky's conception of what makes a financial structure robust or fragile is the relationship between the time pattern of cash commitments and the time pattern of expected cash flows. A firm with cash flows greater than cash commitments for every future period is said to be engaged in hedge finance, because the unit can meet its commitments from its own resources. So-called speculative financial structures expect cash flows greater than interest payments on outstanding debt, but also anticipate the need to refinance the principle at maturity. That makes the firm vulnerable in the event that refinance turns out to be unexpectedly expensive or even unavailable. So-called Ponzi financial structures are even more vulnerable since they anticipate cash flows insufficient even to cover interest payments, so refinance depends on capital gains in the underlying investment as well as general financial conditions.

The normal term structure of fixed-income yields, in which short term debt is cheaper (yields less) than long term debt, usually attributed to a liquidity preference on the part of investors, provides a steady temptation for a descent from hedge to speculative to Ponzi finance. Per Mehrling:

The core idea of the Financial Instability Hypothesis is that there is a built-in tendency for the system to shift over time from robust hedge financial structures to fragile speculative and Ponzi financial structures. A central driver of this tendency is the apparent cheapness of short term finance relative to long term finance, a consequence of liquidity preference which means that wealth holders are willing to accept a lower yield on assets that are more readily (or imminently) turned into current cash. Thus it is always tempting to finance long-lived capital assets with short-term debt, planning to roll over the debt at maturity into another short-term debt. That temptation pushes firms from hedge to speculative finance.

With the passage of time, stodgy investors with memories of previous debacles are pushed aside by brash newcomers who lack the inhibitions of the old-timers. Here's Mehrling again:

The temptation is always there, but in the immediate aftermath of a contraction that has visibly involved the collapse of fragile financial structures, both borrowers and lenders are able to resist the temptation. Liquidity risk is on their minds. Thus, it is only gradually over time that robust financial structures give way to fragile financial structures, as evidence accumulates that giving in to temptation is once again a profitable strategy, for both borrowers and lenders. Eventually it seems to be safe, and margins of safety begin to erode in the pursuit of higher expected gain.

Here's John Cassidy at the New Yorker from 2008 on the subprime mortgage crisis and possible recession:

Twenty-five years ago, when most economists were extolling the virtues of financial deregulation and innovation, a maverick named Hyman P. Minsky maintained a more negative view of Wall Street; in fact, he noted that bankers, traders, and other financiers periodically played the role of arsonists, setting the entire economy ablaze. Wall Street encouraged businesses and individuals to take on too much risk, he believed, generating ruinous boom-and-bust cycles . . . There are basically five stages in Minsky's model of the credit cycle: displacement, boom, euphoria, profit taking, and panic. A displacement occurs when investors get excited about something—an invention, such as the Internet, or a war, or an abrupt change of economic policy . . . As a boom leads to euphoria, Minsky said, banks and other commercial lenders extend credit to ever more dubious borrowers, often creating new financial instruments to do the job... at the top of the market (in this case, mid-2006), some smart traders start to cash in their profits... The onset of panic is usually heralded by a dramatic effect...