How Things WorkMy View On...

My View On: Minsky’s Financial Instability Hypothesis

Hyman Minsky’s Financial Instability Hypothesis (FIH) has been an influential component of how I think of the financial markets and the economy. The FIH, in a nutshell, says that capitalist economies will, at times, deviate from an equilibrium into substantial inflations and deflations. In other words, booms can beget booms which can beget busts which beget busts.

This view, that booms lead to busts, has garnered renewed interest in the wake of the GFC where a housing boom clearly led to a significant economic bust. Additionally, it has put pressure on the more mainstream economic idea that economies are best understood by viewing them thru a state of equilibrium that moves thru periods of trend plus shocks.

The FIH is a two part theory – 1) The economy moves through multiple equilibria with stability tending to lead to instability, and; 2) financing regimes that are stable and unstable with instability tending to result from speculative and ponzi financial regimes.

I generally like the idea that the economy moves through a period of booms leading to busts. But I also like the more mainstream idea that the economy tends to trend and then get shocked. In fact, I am not so sure these concepts are as conflicting as some people seem to think. The primary difference in views is that “shocks” in mainstream macro are unpredictable while “busts” in Minsky are predictable. In my opinion, both views are extreme and can lead to misunderstandings.

The problem here seems, in part, to be terminology. We want to think of the economy in terms of cycles, trends, booms and busts. But what do these terms even mean? After all, the economy does not move in linear trends, mean reverting cycles or predictable booms and busts. It moves from regime to regime which looks like trends or cycles in retrospect but are largely random in real-time.

In my view, we should focus less on these generally vague terms and more on what causes large asymmetric negative economic outcomes to occur. After all, even if Minsky is wrong in assuming that booms will tend towards ponzi finance it is useful to understand the importance of managing potential risks because these negative outcomes have such an asymmetric impact on the economy. For instance, while we can’t know when debt is necessarily speculative or ponzi we can know that excessive debt combined with excessive asset price booms can lead to highly damaging busts. This is why an understanding of debt within the economy has been such a focal point of the weakness in mainstream macro. At the same time, it’s also important not to assume that debt is inherently good or bad. The fact that debt can lead to busts does not mean it must lead to busts.

In short, Minsky’s FIH was ignored for far too long. At the same time, it has the potential to mislead people into thinking that booms are necessarily going to lead to busts and that private debt financed booms will tend to become speculative and ponzi booms. Additionally, the mainstream models that ignored debt and assumed that ponzi booms were unpredictable, is probably extreme. The reality, as is so often the case, lies somewhere in the middle.