Stability begets instability and thus good and stable times sow the seeds of the next bust.
"We fat all creatures else to fat us, and we fat ourselves for maggots. " Hamlet, Shakespeare.
Are we headed for another Minsky moment? Minsky describes how a boom or periods of stability by their nature and human nature cause increased risk taking (for yield and return) which becomes excessive risk taking which leads to bust.
I think this intersects interestingly well with Nassim Taleb's thoughts on antifragility and black swan events. If we are always due for instability then being antifragile is a useful state of being (second best perhaps would be resilience).
My example to explain Minsky would be in housing.
You buy a house with a mortgage loan. The loan costs £100 a month in interest. After costs your rental income is £150 a month. Your finances are more than covered (Minsky describes this as hedged finance). You can afford the interest and repay your capital.
The house market is stable, rising even and you see other landlords make larger levered returns. The long years of stability give you psychological comfort to borrow more.
The loan on your new house now costs £150 in interest a month. The rental income is still £150. You now rely on growth in the house price asset to give you a return as your yield is zero. You can cover your interest costs, but you can not pay down any capital from your rental income. (This isdescribed by Minsky as a speculative borrower). However if house prices rise, the amount of leverage you have will give you large returns. It naturally comes about as people are drawn to higher returns and more leverage as the markets have been stable for so long. The capital loan you owe is only paid back if you sell the asset.
House prices continue to rise, you have seen great returns. The world remains stable. This encourages you to even greater risks, maybe your friends join in too as they've seen so many millionaires being created.
Now the loan on your new house is £200 in interest a month. The rental income is still £150(somehow the bank has been convinced to give you this loan either because you lied, the surveyor lied, or the bank believes in strong capital appreciation). Now you are £50 a month in deficit, and you need strong house price appreciation just to break even. (Minksy calls this Ponzi financing) If this does not happen and you can not meet loan repayments, the bubble bursts and instability occurs. Stretched investor are forced to sell, lowering prices and producing a downwards spiral - a Minksy moment.
Indeed, when growth seems stable, why not borrow more? When bad debt is low, why not lend more ?
This is Minsky's Financial Instability Hypothesis. It seems to me to take human nature at its core and thus also seems to me inevitable. History would suggest this is also true. I would also posit perhaps no matter how hard policy leans against this ultimately the pattern will repeat.
The parallel I draw in nature is with forest fires. This study suggests suppressing the 98% of small fires eventually leads to the 2% of major fires that not only can not be suppressed but because of the successful suppression of earlier small fires leads to an even larger major fire.
Perhaps the answer is then to be ready for the instability as it comes, and even better have the instability make you stronger (cf Taleb's antifragile notions) but at the least be resilient to it.
I can also see a parallel with climate and energy. My reading of Vaclev Smil's position and the current state of affairs suggests that a 3 - 4c warming by 2050 is the most likely scenario (with perhaps the best counter, if we systematically eat less beef; transatlantic flights, car travel and fewer children would also help, but I think less likely to be able to happen), while advocating for change one needs to plan in a resilient/anti-fragile manner for it. I'm very sorry for Bangladesh and Florida. There's a map showing indicated world flooding here.
One reason I like Minsky’s thinking is that it threads human behaviour on to a “macro” effect. I’m typically a micro person, empirically based where I can. Humans often don’t follow the (economic) models! One problem for Minksy’s theory in academic economic world, is there is not mathematical model to test and indeed to some extent it is untestable (as many economic theories are); the empiricist in me doesn’t like untestable theories although we might get better at the testing; and certainly the theory makes you sit back and think.
If you are interested in finding out more; there’s a 2013 conference based on his work you tube below and here and some more presentation links based on his work at that conference.
There’s a more reader friendly piece from Paul McCulley (now retired from PIMCO) who spoke a lot about this in the 2007 to 2009 period.
Much of Hyman Minksy’s work is archived at the Levy Economics Institute. I think this 1992 Hyman Minksy paper is reasonably accessibly for the lay reader (like me!)
a more detailed look at his life's work in the context of economic thinking is on this blog though in my thinking it is the FIH which really stands out.
And below I leave his hypothesis in his own words:
“Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principal out of income cash flows. Such units need to “roll over” their liabilities (e.g., issue new debt to meet commitments on maturing debt).… For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principal or the interest due on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes.… It can be shown that if hedge financing dominates, then the economy may well be an equilibrium-seeking and -containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation-amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.
In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values. "(Minsky 1992, pp. 6 to 8, referred above).
