Financial Instability Hypothesis
The hypothesis of financial instability was developed by the
economist Hyman Minksy. He argued that financial crisis are endemic
in capitalism because periods of economic prosperity encouraged
borrowers and lender to be progressively reckless. This excess
optimism creates financial bubbles and the later busts. Therefore,
capitalism is prone to move from periods of financial stability to
instability. This is a type of market failure and needs government
regulation.
Financial Instability could be summed up as:
Success breeds excess which leads to crisis
Or
Economic stability itself breeds instability. (HOW
STABILITY BREEDS INSTABILITY)
Since the credit crisis, many have looked back at the Great
Moderation (a prolonged period of economic growth during the 1990s
and 2000s) had examined how it contributed to complacency and
risk-taking.
How economies
go from stability to instability
- Traditionally, bank lending is secured against assets. The
lending is hedged against default. For example, banks lend
mortgages if people can raise a deposit and can maintain mortgage
payments to repay both the capital and interest. Typically banks
would also check strict lending criteria to make sure the mortgage
is affordable.
- However, if house prices rise and there is economic growth,
both lenders are borrowers become more optimistic and willing to
take on greater risks.
- Banks insist on smaller deposits and are willing to lend bigger
multiples of income.
- Lending becomes more leveraged.
- The greater lending itself causes asset prices to rise and this
increases confidence even further. People keep expecting rising
prices – the past becomes the guide to the future.
- We could term these sentiments as ‘Irrational exuberance‘ There
is a feeling that the crowd can’t be wrong. If everyone expects
asset prices to keep rising, it’s easy to jump on the
bandwagon.
- Rather than hedge borrowing (safe secured lending) we see a
growth of speculative lending and even ‘Ponzi borrowing’. This
means banks and financial institutions lend money in the hope that
asset prices keep rising to enable repayment. However, the loans of
a Ponzi nature are unsustainable in the long term.
- Regulatory capture. Regulators who should be insisting on safe
lending levels also get caught up in the irrational exuberance.
Credit rating agencies make mistakes in allowing speculative and
Ponzi borrowing.
- However, this asset bubble and speculative lending cannot be
maintained forever. It is based on the unreasonable expectation
that asset prices keep rising beyond their real value. When asset
prices stop rising, borrowers and lenders realise their position
has left them short – they don’t have enough cash to meet their
repayments. Everyone tries to liquidate their assets to meet their
borrowing requirements. This leads to a loss of confidence and
credit crunch.
Minksy Moment
The Minsky moment refers to the point where the financial system
moves from stability to instability. It is that point where
over-indebted borrowers start to sell off their assets to meet
other repayment demands. This causes a fall in asset prices and a
loss of confidence. It can cause financial institutions to become
illiquid – they can’t meet the demand for cash. It may cause a run
on the banks as people seek to withdraw their money. Usually, the
Minksy moment comes when lending and debt levels have built up to
unsustainable levels. It can lead to a balance sheet recession
Implications of Financial Instability
Hypothesis
Minsky argued that because capitalism was prone to this
instability, it was necessary to use government regulation to
prevent financial bubbles. This financial regulation could
include:
- Regulation to prevent speculative and Ponzi lending.
- Requirements banks keep a certain liquidity in cash
reserves.
- Requiring banks to contribute to a stability fund during boom
years, which is to be used in times of crisis.
- Strict requirements for mortgage lending, i.e. not allowing
self-certification mortgages, interest-only mortgages e.t.c.
- Willingness to act on asset price inflation, e.g. raising
interest rates if there is excess house price inflation.
- Splitting up banks between traditional saving divisions and
more risky investment banking.
- A strong Central Bank willing to act as lender of last
resort.
Financial Instability and Credit Crunch
The work of Hyman Minsky was largely ignored by mainstream
economics in the 1970s and 1980s. Instead, there was widespread
support for financial deregulation. But, the credit crisis of 2007
onwards understandably created renewed interest in his work. The
model seemed to offer a considerable explanation for elements of
the credit crisis.
- The movement from hedge lending to speculative and Ponzi
lending, best exemplified by the sub-prime mortgage lending in
America
- The increase in asset prices (especially house prices) above
long-term price to income ratios.
- The growth of confidence in rising asset prices and continued
economic growth.
- The belief we had seen the end of the boom and bust cycle.
- The failure of credit rating agencies to adequately see the
risk in mortgage debt bundles.
- The willingness of commercial banks to borrow money on money
markets to enable more profitable lending.
- A culture of risk-taking emerging in banks, with high rewards
for rapid growth.
We could argue there was a moment between 2003-2004, where
mortgage lending and house prices became unsustainable. However, it
took a few more years for the financial bubble to burst with
devastating consequences. ‘The Minksy Moment’
Limitations of Financial Instability
Hypothesis
- Government regulation of financial markets is often more
difficult in practice than theory. Financial firms have ways of
avoiding government regulation.
- Regulators may fail because they get caught in same ‘irrational
exuberance’
- Financial instability is not the only cause of the 2008 crisis.
For example, we had a prolonged growth in total debt levels, there
was evidence of global imbalances, with large current account
deficits in US, UK and Europe.