Question

• Explain in detail Hyman Minsky’s Financial Instability Hypothesis, using a balance sheet approach.
• Following a financial crisis, private sector balance sheets need to be repaired, and private sector financial behaviour becomes more caution and risk averse. What does this imply for (i) the private sector financial balance (ii) total private sector spending (iii) the government financial balance?

Answer 1

Financial instability hypothesis advocates that the prolonged economic expansion cannot be sustained which is built upon a system of credit and debt so these leads to bubble like situation and it is not sustsinable in nature for the long run.

He advocated that financial cycle are endemic in capitalism because periods of prolonged prosperity made buyers and supplies to be reckless in nature. These cycles which are fuelled by excessive credit and leverage are bound to collapse and hence this can even lead to economic instability because the immediate contraction of an economy can lead to recession and financial instability from the phase of financial stability.

This can even induce an intervention by the central banks as well as Central Government because they want to control the money supply in the economy by regular monetary policies and interventions through various market like equity or currency.

This can also be reflected through balance sheet of various companies which are loaded onto excessive leverage and such assets which quickly lose their value in such contraction phase of economy when the economy grows into complete in stability.