Man of the Moment

Hyman Minsky and the Groundhog Day of Speculative Finance

---

There is no final solution to the problems of organizing economic life.

---

Anyone living through the cascading crises of the post-2000 era needs little convincing of Hyman Minsky’s theory that “stability causes instability.” It is now the eerie calm, the “sound unheard,” that puts modern investors most on edge. Minsky’s theory has an important, often overlooked corollary though: Our destiny to repeat the cycle of crises and bailouts under modern speculative finance. Major crises have, for the most part, been federally short-stopped. Investors have been trained to expect limited pain before the speedy application of either fiscal or monetary analgesic. This is of limited comfort, not unlike chasing a big night out with hair-of-the-dog, the reckoning has merely been delayed not altogether avoided. Economist Joseph Schumpeter wrote regarding the Great Depression:

Any revival which is merely due to artificial stimulus leaves part of the work of depressions un-done and adds, to an undigested remnant of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatening business with another crisis ahead.

Minsky’s big idea predated even Minsky himself in many ways. As we recounted here, Samuel Taylor Coleridge identified the distorting impacts of market serenity in one of his Lay Sermons:

…there have occurred at intervals of about 12 or 13 years each, certain periodical Revolutions of Credit…for a short time this Icarian Credit, or rather illegitimate offspring of CONFIDENCE…seems to lie stunned by the fall…Alarm and suspicion gradually diminish into a judicious circumspectness; but little by little, circumspection gives way to the desire and emulous ambition of doing business;  till Impatience and Incaution on the one side, tempting and encouraging headlong Adventure, Want of principle, and Confederacies of false credit on the other, the movements of Trade become yearly gayer and giddier, and end at length in a vortex of hopes and hazards, of blinding passions and blind practices

A succinct and digestible version of Minsky’s theory of financial instability can be found in a 1986 monograph prepared for The Bank Analyst Conference titled “Stabilizing an Unstable Economy”

An immediate corollary of the endogenous instability of capitalism is that totally free market modern capitalist economy is economically and politically impossible, for in such an economy financial disasters and economic depressions will frequently occur.

Minsky is right; prior to World War II, crises and panics were relatively frequent. Keynesianism ushered in an era of monetary reforms that aimed to smooth the rough ride of capitalism. When he wrote to the bank analyst, more than 40 years had passed without a serious depression. The inherent shortcoming of financial regulation and then reactionary intervention distorts the appropriate market responses to distress. Instead of a conservative retrenchment, there is an implicit assumption that policymakers’ limited tolerance for recession means that forthcoming liquidity will again stoke risk assets.

To the extent that the structural reforms and regulations were effective, they constrained activities that were attractive to at least some players; some profit opportunities were blocked. Such blocked profit opportunities induce market participants to innovate, to develop institutions and instruments that evade or avoid the constraint. Regulatory systems tend to break down, especially after a run of good times during which the disasters, which the regulatory system was designed to prevent or contain, do not occur.

Modern examples abound of the kind of evasion Minsky references. Whether it’s traditional financial institutions becoming “crypto-friendly” or more exotic financial creations like the spectacular rise and fall of Greensill Capital, global finance lacks no creativity when it comes to designing boxes to hold and distribute novel risks that appear staid at first glance. When these risks inevitably bubble to the surface, policymakers, largely academic economists, are ill-equipped to handle episodic crises precisely because their understanding of the world doesn’t include irrationality. Mainstream economics relies on an equilibrium assumption that simply does not correspond with the real world.

Mainstream economics does not help because systemic situations that force interventions...are not possible system states within the standard theory.

It isn’t merely that stability breeds instability, it's that when instability is finally loosed, decision-makers act mainly out of a fear of not acting.

A world is ‘irrational’ to decision-makers when the theory they accept does not explain what happens and therefore does not offer policymakers reasonably argued scenarios about the consequences of different actions.

Minsky, a father of post-Keynesianism, applauded and supported the role of governments in containing financial crises. Yet, he believed their tools were lacking and their reliance on neoclassical models left them reeling when the proverbial dam finally broke. Nonetheless, he maintained that the combination of an implicit lender-of-last-resort in the form of the Fed and the willingness for deficit spending to maintain profits had successfully kept major depressions at bay. Minsky understood the important role of faith in the upward trajectory of modern market economies.

No matter how exalted a bank may have been, we all know that if assets were marked-to-market the net worth of many of the giants of international banking would disappear. Nevertheless, these banks are able to sell their liabilities in financial markets because the buyers believe that they will be protected against losses by the central bank.

Minsky further clarified, presciently, that “‘depositor’ will be broadly defined when a giant bank fails.”