Several economists have referenced the financial instability hypothesis developed by American economist Hyman Minsky to describe modern financial phenomena, especially downturns in the financial system and the economy. As an example, economist Paul McCulley framed his explanation of the causes of the subprime mortgage crisis in the United States that resulted further in the 2007-2008 U.S. Financial Crisis within this hypothesis.
Nevertheless, the financial instability hypothesis provides a model of the modern credit system. To be specific, it explains the behaviors of borrowers, including lenders and government regulators, during economic booms and busts. Minsky laid down more specific arguments and assumptions under this hypothesis.
What is the Financial Instability Hypothesis: The Arguments and Assumptions
1. Boom-and-Bust Cycle in the Financial System and the Need for Regulation
The financial instability hypothesis reiterates one of the main assumptions under Keynesian economics, particularly the notion that a free market economy normally undergoes a boom-and-bust cycle. Take note that this notion contradicts classical economics, which claims that a free-market economy is a self-regulating and self-correcting economic system.
When applied to the financial system, the hypothesis asserts that the system swings between robustness and fragility. These swings are inevitable, and they are a critical component of a general process that generates business cycles. However, government regulation can help control these boom-and-bust cycle both in the financial system and the overall economy.
2. Economic Crisis Due to Debt Accumulation by Non-Government Sector
Another argument under the financial instability hypothesis is that a key mechanism that directs an economy toward a crisis is the accumulation of insolvent debt by the non-government sector. These borrowers include business organizations and households or individuals.
Crisis becomes inevitable because the accumulated debt has grown insolvent. However, Minsky noted that debt insolvency is a result of low interest rates, banking practices, and lack of effective regulation by the government. These factors create an accommodating environment that promotes bankers to readily lend money to borrowers minus due diligence.
3. There are Three Types of Borrowers: Hedge, Speculative, and Ponzi
Minsky also proposed that there are three types of borrowers. These are the hedge borrowers, the speculative borrowers, and the Ponzi borrowers.
The hedge borrowers can repay their debts from their current cash flows from investments. On the other hand, the speculative borrowers are those who have enough cash flow to repay their debt, including the interest, but must regularly rollover or re-borrow a principal. The Ponzi borrowers are those with not enough cash flow from investments to repay their debts but believe that the appreciation of the value of the asset will be sufficient for repayment.
Lending money to Ponzi borrowers will inevitably result in defaults. Eventually, their defaults would create a domino effect that would affect the ability of speculative borrowers to rollover or re-borrower and eventually, the ability of hedge borrowers to find loans. Collectively, these borrowers contribute to the accumulation of insolvent debt.
4. Borrowers Move from a Safe to Risky Area of a Spectrum During Financial Booms
Another key argument of the financial hypothesis is that borrowers move along the so-called Minsky spectrum that includes a safe area and risky area. At times when optimism is high and funds are available, borrowers move from a safe area or the hedge end of the spectrum to the risky area or the speculative and Ponzi end of the spectrum.
The Minsky spectrum also includes the concept called Minsky moment. It is characterized by a sudden and significant collapse of asset values. To be specific, long periods of stability and investment gains leave lenders, borrowers, and regulators complacent, thus resulting in a diminished perception of risk. Complacency allows borrowers to move to the risky end of the Minsky spectrum until the overall financial system reaches a Minsky moment.