Question

Explain the “3” Minsky stages of financial instability.

Answer 1

Minsky broke down the process from financial stability to instability into three types of debt phases: hedge, speculative, and Ponzi.

In the Hedge Phase, buyers' cash flows cover interest and principal payments for borrowers who go into debt to buy an asset. So,the debt is self-liquidating, fully hedged, so it is a stabilizing factor in this economic phase.

In the speculative phase, cash flows cover only interest payments, but not enough to amortize the principal. Obviously, this is less stabilizing since borrowers are betting on the idea that the interest rate is not going up, and the value of the collateral will not decline. The longer an economy is stable, the more there is an incentive to speculate, and the more speculative borrowers become.

The Ponzi Phase is the last phase toward the end of the bubble. In this phase, cash flows cover neither interest rate nor principal, and it all depends on rising asset prices to keep the borrowers afloat. As opposed to the Speculative Phase, this whole phase is hinged on asset price (or operating profit margin for private equity firms) going up.

In this three-step process, the markets become more risky as they appear to become more stable. The longer the markets seem to be stable, or appear more secure, the more risky and unstable they become. The false hope of security leads investors to extrapolate stability into the distant future.