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We Should Have Seen It Coming…
Hyman Minsky and
the Economic Meltdown

Hendrik van den Berg
UNL Professor of Economics

One of the surprising things about the 2008 financial collapse was that mainstream economists and financial experts completely failed to anticipate it. But, what else could we expect from people who based their worldview on ‘neo-liberal’ economic models that assume people behave rationally, that market prices always reflect the true value of everything, and that the financial industry efficiently spreads risk to those who can best bear it.

Still, some economists should have foreseen the pending financial disaster. Interestingly, there was one economist who predicted the financial collapse right here in the Midwest: the late Hyman Minsky of Washington University in St. Louis.

Minsky’s Financial Instability Hypothesis

Hyman Minsky expanded the ideas of the notable British economist John Maynard Keynes to develop his “Financial Instability Hypothesis.” This hypothesis not only explains the recent ‘housing bubble’ that was financed by the global sales of securities backed by subprime mortgages, but it also explains why the world was so surprised by the subsequent financial crisis.

Like Keynes, Minsky understood that investment was the source of economic instability. Also like Keynes, he understood that in a modern economy investment is financed through an intermediary financial system with a life of its own. He then extended Keynes’ reasoning by detailing how the stability of the financial system depends on the types of financing the financial industry provides. Specifically, financial stability depends on the relative dominance of ‘hedge finance,’ ‘speculative finance’ and ‘Ponzi finance.’

‘Hedge’ financing means a project’s cash flow covers not only all the required interest or dividend payments, but the cash flow also suffices to pay off all debt by the scheduled due dates. ‘Speculative’ projects are a bit more precarious in that they meet their interest, dividend, or expected profit payments, but everyone recognizes that it will be necessary to ‘roll over’ some of the debt when it comes due. Many new projects, newly formed businesses and innovative activities are speculative in nature. While such projects individually are not a concern for the health of the financial system, if a large proportion of an economy’s investment projects are financed this way, the financial system could become unstable should credit suddenly become less plentiful or financial markets freeze.

Changes in economic conditions, however, can cause viable speculative businesses to suddenly become ventures whose cash flows from operations are not sufficient to meet even interest or dividend payments—much less cut into the outstanding debt. Minsky called these “Ponzi ventures” because (in the tradition of true Ponzi schemes) new borrowing is needed just to cover the project’s day-to-day payments.

The precise mix of hedge, speculative and Ponzi financing depends on economic conditions and the regulatory structure that governs the activities of the financial industry. Fundamentally, it is the responsibility of the financial sector, its auditors and regulators, and macroeconomic policymakers to prevent the growth of speculative and Ponzi financing. The 2008 financial crash revealed the gross failure of the financial industry, its regulators and macroconomic policymakers to police investment practices. Had he been alive, Minsky would not have been surprised by these failures.

Financial Instability Is Inevitable

Way back in 1982, in a volume entitled, Can ‘It’ Happen Again?, Minsky argued that every prolonged period of economic growth, if left to run its course, will always end in a financial collapse: “Stability — or tranquility — in a world with... capitalist financial institutions is destabilizing.” Minsky drew on Keynes’ 1936 General Theory of Employment, Interest and Money, whose Chapter 12 so brilliantly described the precarious nature of long-term investment. According to Keynes, investors and innovators must reach a decision on whether to invest, and lenders must decide whether to lend, even though their “knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible.” Without exact knowledge of the future, investors and lenders rely on “confidence” and “convention,” which Keynes also referred to as “animal spirits.” “Convention” refers to our understanding of how things will pan out. You might think of convention as a popular economic model. Keynes argued that people remain confident and willing to engage in investment and innovative activities with uncertain outcomes as long as outcomes from recent investments were what they came to view as ‘normal.’

Critical to Minsky’s hypothesis is Keynes’ observation that investors and lenders tend to focus on the near past rather than the distant past when they shaping their expectations of the future. Keynes wrote: “It is reasonable... to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other facts about which our knowledge is vague and scanty.” Keynes’ observation about people’s reliance on the recent past was quite accurate and has been validated by recent psychological research. Psychologists have found that people discount the past, just as they tend to discount the future, relative to today. Minsky thus concluded that the longer economic growth continues, the more we expect it to continue, because the last recession or financial collapse fades farther into the past. Expectations accordingly become increasingly optimistic, and the longer the good times last, investors convince themselves that the world is now in some way different from what they view as a progressively remote and irrelevant past.

The recent financial crisis clearly validates Keynes’ and Minsky’s observations that the recent past disproportionately determines investor and lender expectations. In fact, many of the risk models used in the financial industry (such as those that led Joseph Cassano of A.I.G.’s London Financial Products Division to claim that he did not “see a scenario within any kind of realm of reason that would see us losing one dollar”) were estimated using data going back as few as five years. The financial models would have predicted more accurately if their parameters had been estimated taking into consideration the Great Depression from 70 years ago. But that is not how even those really smart people who were paid very high salaries actually set their expectations or, apparently, how the financial geeks estimate their sophisticated financial models.

The process of rising expectations may continue for some time, but as expectations rise above long-run sustainable trends, those projects investors and lenders believe to be ‘hedge’ projects become increasingly ‘speculative,’ and those that are believed to be speculative are really ‘Ponzi’ financing when true long-term trends are taken into consideration. Sooner or later, the long-term trends manifest themselves, speculative financing cannot be rolled over, and the financial sector finds itself with a lot of Ponzi financing arrangements. A financial collapse causes investment to plummet, and an economic recession results.

Deregulation and Long-Run Memory Loss

Minsky’s financial instability hypothesis applies not only to actual investors and lenders, but also to the policymakers and economists who shape financial regulation and macroeconomic policies. The recent deregulation of the financial industry in most countries around the world is a clear manifestation of the focus on recent events and the fading of the distant past. When, in the late 1990s, the Clinton Administration, advised by economists and financial industry lobbyists, pushed to repeal the 1933 “Glass-Steagall Act” and thus permit banks and insurance companies to again engage in the risky investment activities that helped cause the Great Depression, it clearly did not consult Hyman Minsky.

Unfortunately, Hyman Minsky is no longer with us today. But we can still heed his insights that explain the 2008 financial collapse so very well. Clearly, we need much tighter regulations to limit the risks lenders take with other people’s money and the unrealistic “confidence” of investors who seek to profit from stock market and real estate bubbles.

But, the U.S. financial industry has, so far, lobbied very hard to limit regulatory changes. Less than a month after JPMorgan, Chase, Goldman Sachs, Citigroup and Bank of America accepted billions in government assistance, they created a lobbying group (the CDS Dealers Consortium) to fight against any increased regulation of some of the recent financial innovations that caused the 2008 financial crisis. Also disturbing are the direct links between policymakers and financial industry management, as evidenced by the number of former investment bankers in the Obama Administration.

As of this writing, no major regulatory changes have yet been put in place in the U.S. or the United Kingdom. The British historian/writer John Lanchester recently explained this inaction in a London Review of Books article under the title, “It’s Finished”:

The Anglo-Saxon economies [Britain and the U.S.] have had decades of boom mixed with what now seem, in retrospect, smallish periods of downturn. During that they/we have shamelessly lectured the rest of the world on how they should be running their economies. We’ve gloated at the French fear of debt, laughed at the Germans’ 19th-century emphasis on manufacturing, told the Japanese that they can’t expect to get over their ‘lost decade’ until they kill their zombie banks, and so on. It’s embarrassing to be in worse condition than all of them.

Lanchester suggests that instituting new regulations on British and American banks or breaking up large financial conglomerates “would mean that the Anglo-Saxon model of capitalism had failed.” That is, we have, so far, replaced our ignorance of the distant past and disproportionate focus on the recent past with an obstinate refusal to look back at all. The financial industry, no doubt, hopes that this obstinate blindness will last long enough for the massive taxpayer-funded bailouts and fiscal stimuli to start the next economic bubble.