With the level of consumer debt in the United States doing this:
…and with house affordability in some markets declining like this:
The financial instability hypothesis is simply explained as a theory of the impact of debt on the economy and the manner in which that debt is validated. In a capitalist economy, the money flows from depositors to banks from banks to firms and, in the future, from firms to banks and then back to depositors. The flow of money to firms occurs because there is an expectation of future profits and the flow of money from firms is financed by profits. Therefore, as you can see, in a capitalist economy, the past, present and future are linked by financial relationships between parties. The capitalist system is complicated by the accrual of debt; households use credit to purchase consumer goods and houses, businesses use debt to expand and governments use debt to fund their operations. The financial instability hypotheses focuses on the profit-seeking activities of banks who grow their profits through financing economic activity in both the consumer and corporate sectors.
Minsky proposes three distinct types of debt units:
1.) Hedge (no relation to hedge funds) – these financing units can fulfill all of their contractual payment obligations through cash flow.
2.) Speculative – these financing units can meet their payment commitments on the “income amount” on their liabilities but cannot repay the principal out of their cash flows. These debt units need to roll over their liabilities to continue to make their payment commitments, for example, these units need to issue new debt to meet the commitments on their old debt – a prime example being government bonds which is never repaid but is rolled over as new bonds are issued to replace the maturing bonds.
3.) Ponzi – these financing units have cash flow that is insufficient to fulfill either the payment of interest due on the outstanding debt or to repay the debt principal. These financing units can only sell assets or borrow more to pay what is owed. As we all know, a Ponzi financing unit is an unsustainable model of debt and greatly lowers the margin of safety for debt holders.
Now that we have that background, let’s look at Minsky’s key conclusion:
The financial instability hypothesis has two theorems:
1.) the economy has financing regimes under which it is stable and financing regimes under which it is unstable.
2.) 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 i.e. the system will move from hedge finance units to speculative finance units to Ponzi finance units.
Here is another quote:
“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.”
In other words, the longer that people make money by risk-taking, the more likely they are to make incautious financial decisions. We need think no further than the massive economic instability created by the American banking sector which graciously extended mortgage funding to people who could ill-afford to purchase a house and the investment banking sector and their imaginative use of mortgage-based securities backed by these mortgages that ultimately proved to be worthless.
Here is a quote from the paper by Paul McCulley:
“The essence of the hypothesis is that stability is destabilizing because capitalists, observing stability in the present, have a herding tendency to extrapolate the expectation of stability out into the indefinite future, putting in place ever-more risky debt structures, up to and including Ponzi units, that cause stability to be undermined.
Minsky’s theory clearly explains the boom-bust cycles that those of us who live in a capitalist system are very well acquainted with. Economic stability begets economic instability because of the asset price increases and resulting credit excesses that they create and our inherent belief that nothing will ever go down in price, most particularly housing, a belief that proved to be profoundly wrong.
Given the fact that consumer debt in the fourth quarter of 2017 is now 18 percent above its post-Great Recession low in 2013 and is now $473 billion above its 2008 high, it is increasingly appearing that, once again, we are retracing the steps taken prior to the Great Recession and are setting ourselves up for the next economic contraction. With the Federal Reserve lulling us into a sense that the “interest rate good times” will never really end (or, if they do, they will quickly retrace their steps back to zero percent), consumers are creating the next period of economic instability, suggesting that the painful debt lessons of the Great Recession have long been forgotten.
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