Classic Paper: Financial Instability Hypothesis

We occasionally select for retrospective review an all-time “best selling” research paper of the past from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize Hyman Minsky’s May 1992 paper entitled “The Financial Instability Hypothesis” (download count over 3,400), a theory of the impact of debt on economic system behavior. The Financial Instability Hypothesis (FIH) challenges the view that a capitalist economy with a sophisticated financial system constantly seeks equilibrium, instead proposing that some conditions are deviation-amplifying. Specifically, he proposes that:

• The key determinant of capitalistic financial system behavior is the level of profits, driven by aggregate demand. The expected level of profits attracts financing (an exchange of present money for future money), and the actual level of profits resolves the resulting financial repayment obligations as viable or not.
• There are three types of financing:
  1. Hedge financing is that for which cash flows from operations cover all contractual repayment obligations.
  2. Speculative financing involves cash flows from operations that can pay interest on debt obligations but cannot repay principle.
  3. Ponzi financing involves cash flows from operations insufficient to cover either the interest on debt obligations or repayment of principle.
• Over periods of prolonged prosperity, capitalist economies tend to escalate risk by migrating from hedge financing (stable, equilibrium-seeking) to speculative and Ponzi financing (unstable, deviation-amplifying). Further, government attempts to quell inflation tend to transform speculative financing into Ponzi financing. The ultimate resolution of unstable financing is liquidation and collapse of asset prices.
• Business cycles of varying length and depth derive from this dynamic and from the associated government interventions and regulations designed to moderate the variation.

In summary, investors may want to consider the cycle of stability, instability and collapse proposed via the Financial Instability Hypothesis (though unquantified) in judging the state of financial markets.