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Hyman Minsky on financial crises

by das monde Thu Mar 22nd, 2007 at 10:20:48 AM EST

Recently, I wrote a diary with one of speculations that speculative markets (such as stock and real estate markets) tend to behave like pyramid schemes at certain stages (like now). The crucial feature is the point when the market valuation grows predominantly because of outsiders entering the market with expectations of profitting from the steadily growing market. When the market volume has nowhere to grow, the latest entrants (if only) suffer dearly.

I am content to find out that my suspicion is not a wack unseen to human mind. Please enter Prof. Hyman Minsky (1919-1996), and his Financial Instability Hypothesis.

From the diaries ~ whataboutbob

Just a look at the list of Minsky's major works tells that he thought a lot about financial crisises.

[Minsky] theorized that financial fragility is a typical feature of any capitalist economy. High fragility leads to a higher risk of a financial crisis. To facilitate his analysis Minsky defines three types of financing firms choose according to their tolerance of risk. They are hedge finance, speculative finance and Ponzi finance. Ponzi finance leads to the most fragility.

Ponzi finance obviously refers to Ponzi schemes, which are pretty synonymous to pyramid schemes for our purposes.

In Minsky's own words (1974): "The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable.

The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.

In particular, over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make positions by selling out positions. This is likely to lead to a collapse of asset values."

A more technical summary and the 1992 version of Minsky's clarifications are available here.

The internets are already buzzing with relating Minsky's theory to the current situation of the real estate market. Here is a nice summary of the typical bubble cycle.

Stage One - Displacement

Every financial crisis starts with a disturbance. It might be the invention of a new technology, such as the internet. It could be a shift in economic policy. For example, interest rates might be reduced unexpectedly. Whatever it is, the world changes for one sector of the economy. People see the sector differently.

Stage Two - Prices start to increase

Following the displacement, prices in the displaced sector start to rise. Initially, the price increase is barely noticed. Usually, these higher prices reflect some underlying improvement in fundamentals. As the price increases gain momentum, people start to notice.

Stage three - Easy Credit

Increasing prices are not enough for a bubble. Every financial crisis needs rocket fuel and there is only one thing that this rocket burns - cheap credit. Without it, there can be no speculation. Without it, the consequences of the displacement peter out and the sector returns to normal.When a bubble starts, the market is invaded by outsiders. Without cheap credit, the outsiders can't join in.

Cheap credit is the entrance ticket for outsiders. For example, gas prices have risen sharply in recent years. However, banks aren't giving out loans so that people can store gas in their garages in the hope that the price will double in three months. The banks, however, are prepared to give loans to people with poor credit to hold condos in the hope that they can be quickly flipped.

The rise in easy credit is also often associated with financial innovation. Often, a new type of financial instrument is developed that miss-prices risk. Indeed, easy credit and financial innovation is a dangerous cocktail. The South-Sea Bubble started life as new-fangled legal innovation called the limited liability joint stock company. In 1929, stock prices were propelled into the stratosphere with the help of margin calls. Housing prices today accelerated as interest-only mortgages emerged as a viable means for financing overpriced real estate purchases.

Stage Four - Over-trading

As the effects of easy credit kicks in, the market starts to overtrade. Overtrading stimulates volumes and shortages emerge. Prices start to accelerate, and easy profits are made. More outsiders are attracted, and prices run out of control. Accelerating prices attract the foolish, greedy and the desperate to enter the market. As a fire needs more fuel, a bubble needs more outsiders.

Stage five - Euphoria

The bubble now enters its most tragic stage. Some wise voices will stand up and say that the bubble can no longer continue. They put together convincing arguments based upon long run fundamentals and sound economic logic. However, these arguments evaporate in the heat of the one over-riding fact - the price is still rising. The wise are shouted down by charlatans, who justify insane prices by the euphoric claim that the world is different and this new world means higher prices.

Of course, the "new world" claim is true; the world is different every day, but that doesn't mean that prices run out of control. The charlatan wins the day and unjustified optimism takes over. At this point, the charlatans bolster their optimism with the cruelest of all lies; when prices finally reach their new long run level, there will be a "soft landing". The idea of a gentle deceleration of prices calms the nerves.The outsiders are trapped in knowing denial. They know that prices can't keep rising forever, but they rarely act on that knowledge. Everything is safe so long as they quit one day before the bubble bursts.Those that did not enter the market are stuck in a terrible dilemma. They can not enter but neither can they stay out. They know that they have missed the beginning of the bubble. They are bombarded daily with stories of easy riches and friends making massive profits. The strong stay out and reconcile themselves to the missed opportunity. The weak enter the fire and are damned.

Stage Six - Insider profit taking

Everyone wants to believe in a new brighter future but a bubble takes that desire and turns it upside down. A bubble demands that everyone believes in a brighter future, and so long as this euphoria continues, the bubble is sustained. However, as madness takes hold of the outsiders, the insiders remember the old world. They lose their faith and start to panic. They understand their market, and they know that it has all gone too far. Insiders start to cash out. Typically, the insiders try to sneak away unnoticed, and sometimes they get away with it. Other times, the outsiders see them as they leave. Whether the outsiders see them leave or not, insider profit taking signals the beginning of the end.

Stage seven - Revulsion

Sometimes, panic of the insiders infects the outsiders. Other times, it is the end of cheap credit or some unanticipated piece of news. But whatever may be, euphoria is replaced with revulsion. The building is on fire and everyone starts to run for the door. Outsiders start to sell, but there are no buyers. Panic sets in; prices start to tumble downwards, credit dries up, and losses start to accumulate.

Here is the paradox of all bubbles - everyone knows how the fatal combination of easy credit, overtrading and euphoria will affect prices. Minsky didn't need to write down a thing about the madness of speculation. America's investors have a lifetime of experience. Within the space of five years, America moved from the tech stock bubble into the real estate bubble.Today's housing prices are grossly overvalued. Everyone knows that prices will collapse. It might be tomorrow, or it might be two years from now. One thing, however is certain, the longer it takes for the bubble to burst, the more painful it will be.

New technology "disturbances", easy credit, enthusiastic trading, euphoria... What are we missing?

In a way, we can see that Bush's tax cuts, financial and corporate policies have impressive workings. By encouraging (or forcing, also indirectly via pension funds) people to enter financial and real estate markets, by running up debt (in effect, at the cost of Social Security) they vastly increased demand for stocks and real estate. The demand growth is self-inforcing and self-necessary, just as in a Ponzi scheme. But once the demand hits a ceiling... you can bet, there won't be many buyers.

Minsky's theory is "most applicable to a closed economy". Some bubles might have to collapse by now already, but the process of globalization spreads markets and the pool of outsiders entering them. Hence, the bubbles may keep growing. The recent stock market "corrections" are good indications of this process: the Shanghai dip of 3 weeks ago was provoked by rumours that Chinese government may try to curb market speculations more seriously.

Is a colossal collapse of all bubbles eminent? Perhaps there is still enough room for critical bubbles to grow for a few years, or yet another election cycle. But it would be downright immoral and dangerous to rely on that. Something more intelligent can be done, I believe.

It is pretty amazing that knowing so much about financial cycles, the Bush and other world administrations encourage precisely a path to a sharp crisis. Yes, the path does produce excitement of easily growing wealth - just as a pyramid scheme.

Can we enjoy a financial meltdown now?

When is the Second Great Depression coming?
. This spring 0%
. By the end of this year 21%
. Next year 15%
. In 2009 10%
. In 2010 0%
. By 2015 10%
. By 2020 5%
. This depression won't be great 31%
. There won't be other great depressions 5%
. Markets will keep going up 0%

Votes: 19
Results | Other Polls
I know, the opening sentence is terrible. But perhaps appropriately so.

Crossposted at Booman Tribune as well.

When is the best time to put it at Daily Kos?

by das monde on Tue Mar 20th, 2007 at 07:46:00 AM EST
Now crossposted at Daily Kos as well.
by das monde on Wed Mar 21st, 2007 at 07:06:28 AM EST
[ Parent ]
Looks like you fell down the queue though.  Sorry.  

(My OTHER gripe about D.kos:  It is time for him to redisign the software to adapt to the huge size.)  

I thought it was a good thread though, if small.  

Interesting that folk there thought the crash will come sooner ('09) than here ('15)0--though it is bimodal.  

The Fates are kind.

by Gaianne on Thu Mar 22nd, 2007 at 01:48:09 AM EST
[ Parent ]
Minsky's theory is "most applicable to a closed economy". Some bubles might have to collapse by now already, but the process of globalization spreads markets and the pool of outsiders entering them. Hence, the bubbles may keep growing. The recent stock market "corrections" are good indications of this process: the Shanghai dip of 3 weeks ago was provoked by rumours that Chinese government may try to curb market speculations more seriously.

The global economy is a closed economy, by definition.

"It's the statue, man, The Statue."

by Migeru (migeru at eurotrib dot com) on Tue Mar 20th, 2007 at 07:51:22 AM EST
Minsky seems to follow a long line of thinkers who find capitalism inherently unstable.  Of course, "it's just the normal business cycle", right?
by andrethegiant on Tue Mar 20th, 2007 at 10:14:20 AM EST
I'm not sure economic cycles have anything intrinsic to do with capitalism. All you need is delayed feedback to produce boom-bust behaviour.

"It's the statue, man, The Statue."
by Migeru (migeru at eurotrib dot com) on Tue Mar 20th, 2007 at 10:19:33 AM EST
[ Parent ]
I was looking at Kondratiev waves


and wondering to what extent we are seeing credit financing the creation of new waves of technology to give the upswing followed by periods of repayment of the debt (and hence monetary contraction in a deficit-based monetary system) from the revenues from the new generation of productive assets, on the downswing.

So cycles - bounded by the mathematics of compound interest on the money supply - would be intrinsic to our current - deficit-based - form of Capitalism.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Tue Mar 20th, 2007 at 11:22:12 AM EST
[ Parent ]
I am saying I don't believe the cycles would go away if you removed debt, because of the delayed feedback involved in the economic system in any event.

As to the severity and character of the cycles, sure.

"It's the statue, man, The Statue."

by Migeru (migeru at eurotrib dot com) on Tue Mar 20th, 2007 at 11:28:05 AM EST
[ Parent ]
Capitalism seems to "thrive" on instabilities. Libertarians just do not accept any damping measures. They hail GDP growth as the holy grail. As for crisises - well, they are swift but rare and short.

In particular, experienced stock traders are surely aware of Ponzi modes in one way or other. Taking benefit from that must be a usual buisiness for them. Predicting moods of new market players is even an easier task than estimating "intrinsic" value of companies. (This is akin to the job of bookmakers: they do not really predict sport events; they just have to predict moods of participating betters. If they force bets to be distributed evenly, bookmakers win their daily bread with any outcome of the sport event.)

by das monde on Tue Mar 20th, 2007 at 08:57:17 PM EST
[ Parent ]
Bookmakers don't need to force bets to be distributed evenly: they just need to continually adjust the odds to respond to the changing mood of the bettors.

"It's the statue, man, The Statue."
by Migeru (migeru at eurotrib dot com) on Wed Mar 21st, 2007 at 02:25:18 AM EST
[ Parent ]
If I look at the crisisses I know, the Ponzi element can be clearly distinguished. The Russian crisis had a clear Ponzi scheme with GKO bonds running. The Asian crisis embraced attractive interest rates, high inflow of money and rocketing asset prices.

Japanese real estate crisis was fuelled by the saving policies of the postwar years. This does not look much like a Ponzi scheme, but the role of relaxed money supply (and exploding asset demand) is clearly visible.

The Great Depression came clearly from a speculative boom. Automobiles and radio were the expanding new technologies. Easy credit was stimulated. Americans were encouraged to borrow and spend. Surely, there must have been a runaway Ponzi element somewhere.

The Bush admistration is on the same path. Maybe they genuily think they can avoid critical mistakes and repeat a guilded age boom in "a right way". Or maybe "they" cynically see an opportunity to enrich an insider ring with a hidden global Ponzi machine most effectively.

It seems to me that whenever you run up a sure Ponzi scheme on the scale of a whole market, you must hit a crisis regardless of the phase of the economic cycle. Since Ponzi schemes are very unstable, consequences must be evident within a few years.

What is the sense of Kondratiev type macrocycles within this framework? I see two possible features.

For once, a prosperous phase might increase money supply greatly. This does not automatically induce a Ponzi trading, but the potential is there to be crystalized. Once the public is overexited, or the government relaxes control for maximal bang, Ponzi snowballs start rolling.

Secondly, the whole economy might contain a very weak Ponzi element. Most of the time, the Ponzi element is undetectable. But it does gain substance within decades, and then boom-busts in a few years.

by das monde on Tue Mar 20th, 2007 at 09:59:09 PM EST
[ Parent ]
Scenerio I:  

Bush and his wealthy backers are greed-crazed idiots.  They don't even know what they are doing.  It is like a drug binge, where even if you can remember that last time you ended in a dreadful crash, right now it feels just too good to be thinking about that.  

This scenerio is almost comforting.  

Scenerio II:  

Bush's backers have been running the US for the better part of a century, and not by being dumb, either--even if HE is.  They know they are running a bubble, and they already know when to cash out.  Will it destroy the system?  Sure.  But Peak Oil and climate change are on the verge of doing that anyway, so what's the problem?  The problem is what comes after.  Well, they are not talking about that, but they have certainly been THINKING  about that.  

They already have plans.  

This scenerio is less comforting.  

The Fates are kind.

by Gaianne on Tue Mar 20th, 2007 at 11:45:31 PM EST
[ Parent ]
Albania in 1997 was a wake-up for me:

Many citizens naive to the workings of a market economy put their entire savings into pyramid schemes. In a short while, $2 billion (80% of the country's GDP) had been moved into the hands of just a few pyramid scheme owners, causing severe economic troubles and civic unrest. Police stations and military bases were looted of millions of Kalashnikovs and other weapons. Anarchy prevailed,[4] and militia and even less-organized armed citizens controlled many cities.

Thus described by wikipedia.

I remember reading an in-depth article at the time. According to it (and my memory) it was not a strict pyramid scheme, but rather a bubble turned Ponzi. The bubble started from political changes in the area, that is the wars in what was soon to be former Yugoslavia and the sanctions put in place.

Albanian groups started to smuggle sanctioned stuff and made lots of money. Their was room for expansion and more and more people invested and got rich. The Dayton agreement of 1995 removed the foundation for the investment scheme but by then the speed was great enough that it could carry on until 1997 on pure momentum. But the day came when all savings had been sucked up and then the ineviteble collapse.

This was refered to as a pyramid scheme by western media and that got me thinking about the raising stocks at the time (1997) when everyone was becoming an investor and especially in technological stocks. So I figured that that must be a bubble too and predicted a crash in 1998. Apparently I underestimated how big bubbles can be.

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Thu Mar 22nd, 2007 at 11:15:32 AM EST
[ Parent ]
Capitalism has a "natural business cycle" because it is based on the same binge-and-crash structure as drug addiction.  

The Fates are kind.
by Gaianne on Wed Mar 21st, 2007 at 02:06:57 AM EST
[ Parent ]
Economies have a natural business cycle because of delayed feedback.

"It's the statue, man, The Statue."
by Migeru (migeru at eurotrib dot com) on Wed Mar 21st, 2007 at 02:29:05 AM EST
[ Parent ]
Also, incomplete.  

(Umm.  Oh, yes:  Drug binges have delayed feedback, too.)  

The driving force is undamped POSITIVE feedback.  

If the 19th century was learning about the destabilizing effect of positive feed back, the 20th was about how external (political) attempts to apply appropriate negative feed back can be successful, but are readily subverted.  

So that the system, as a whole, is again unstable.  

Living systems seem to deal with this problem by increasing their complexity, and the extra layers of feedback yield increased resiliency.  

Capitalist political economies move the opposite way--toward simplified structures.  Capitalism does to the human environment what it does to the physical environment--desertifies it.  

The Fates are kind.

by Gaianne on Wed Mar 21st, 2007 at 03:47:39 AM EST
[ Parent ]
Okay, let's say that the economic system is unstable [positive feedback by definition] against growth of new modes of economic activity and that delayed feedback and imperfect information lead to overshoot and collapse oscillations of the size of economic sectors instead of logistic growth/contraction.

"It's the statue, man, The Statue."
by Migeru (migeru at eurotrib dot com) on Wed Mar 21st, 2007 at 06:02:08 AM EST
[ Parent ]
Just for the fun of it, I googled "Veblen Minsky" together.

Title: A Veblenian View of Minsky's Financial Crisis Theory
Author(s): Patrick R. Kelso, Barry L. Duman
Journal: International Journal of Social Economics
Year: 1992 Volume: 19 Number: 10

Abstract: Compares and contrasts the views of Hyman P. Minsky and Thorstein Veblen concerning the systematic development of financial crises in capitalistic economies. Advances the argument that Minsky and Veblen have both successfully met the challenge of providing a reasonable explanation for the speculative mania and related excesses critical to any theory of cyclical fluctuations. They agree that upturns tend to euphoria and ultimately, over-capitalization and subsequent economic decline. Their rationales differ. Veblen stresses the effects of rising prices on collateral values and argues that the cumulative effect is over valued assets. Minsky seems to emphasize the ever-growing fragility of financial structures. In the view of the authors, this article places Veblen′s contributions in a contemporary setting and ties Minsky more closely to the institutionalists.

Echoes of Veblen's theory of business enterprise in the later development of macroeconomics: Fisher's debt-deflation theory of great depressions and the financial instability theories of Minsky and Tobin

Authors: Robert W. Dimand

Abstract: Irving Fisher's debt-deflation theory of great depressions, first published in 1932 and 1933, was invoked by Hyman Minsky and James Tobin as a crucial precursor of their theories of macroeconomic financial instability. This paper argues that Wesley Mitchell was right to perceive a close intellectual affinity between Fisher's debt-deflation theory and Thorstein Veblen's Theory of Business Enterprise (1904), and that this affinity also exists between Veblen (1904) and the analyses of Minsky and Tobin.

Minsky's Analysis of Financial Capitalism

Authors: Dimitri B. Papadimitriou, L. Randall Wray

Abstract: In this paper, the authors discuss Minsky's analysis of the evolution of one variety of capitalism-financial capitalism-which developed at the end of the nineteenth century and was the dominant form of capitalism in the developed countries after World War II. Minsky's approach, like those of Schumpeter and Veblen, emphasized the importance of market power in this stage of capitalism. According to Minksy, modern capitalism requires expensive and long-lived capital assets, which, in turn, necessitate financing of positions in these assets as well as market power in order to gain access to financial markets. It is the relation between finance and investment that creates instability in the modern capitalist economy. Financial capitalism emerged from World War II with an array of new institutions that made it stronger than ever before. As the economy evolved, it moved from this more successful form of financial capitalism to the fragile form of capitalism that exists today.

[People] have conditions today that resemble those of nearly a century ago that evoked Thorstein Veblen's (1904) observation that capitalism encouraged the pursuit of pecuniary gain at the expense of social provisioning. Not only do corporate managers attempt to please security holders by encouraging regulators to relax environmental standards and by increasing their market power, their ruthless expense cutting has, as described by Minsky and Charles Whalen (1996-97), increased economic insecurity and inequality for most working families.
by das monde on Wed Mar 21st, 2007 at 06:43:25 AM EST
Can I get you to cross-post this?  It makes a wonderful counterpoint with Techno's Veblen piece, which was also cross-posted.

The Crolian Progressive: as great an adventure as ever I heard of...
by Nonpartisan on Thu Mar 22nd, 2007 at 07:30:30 AM EST
It seems that the most widespread technical term for the (yet "mysterious") processes that preclude financial crisises is overheating. For example, there is much concern at the moment about overheating in the Baltic markets. Here is a global news report:
Is Latvia's economy following in Iceland's overheated footsteps?

WARSAW: Latvia is giving some emerging market investors a sense of déjà vu.

A year ago the economy of tiny Iceland went into a skid. It was a wake-up call for traders who chased high yields around the globe with little regard to economic risks.

Now, another small, red-hot economy in Europe's cold north is in the spotlight, and markets are taking a hard look at its peers for signs of trouble brewing elsewhere.

The verdict is that many show similar worrying symptoms -- an unsustainable pace of growth fueled by booming consumption and credit, high foreign debt, surging wages, current account deficits topping 10 percent of gross domestic product and low currency reserves.

[Danske Bank] analyzed 11 "vulnerability indicators" for the 10 European Union members from Eastern Europe, putting Latvia and its neighbors Estonia and Lithuania, as well as Romania and Bulgaria, in the red danger zone.

The booming Slovak economy got a yellow warning light.

The process is admittedly enigmatic, but they have vulnerability indicators. Just do a Google search on "overheating vulnerability indicators", and you will get many PDF articles returned on the stuff.

How much common or different is between these three terms?

  1. Overheating
  2. Financial bubble
  3. Minsky's Ponzi financing

Is "overheating" just a less scary euphemism for the same thing? Are we having a global financial warming?!
by das monde on Fri Mar 23rd, 2007 at 02:16:40 AM EST
Here are a couple of links from IMF:
The Challenges of Predicting Economic Crises
The Asian Crisis: Causes and Cures

Even with most official terminology, prediction of financial crises looks very much like fortune telling, as evidenced by this abstract:

This paper examines the view that the recent Indonesian crisis was largely unforeseen. The broadest macroeconomic indicators were of virtually no help in presaging the crisis; neither were high-frequency financial indicators. But warnings were there, just below the surface, in some of the macro indicators and in certain structural weaknesses that were long recognised as threats to financial stability. That said, none of these warnings suggested crisis of the magnitude that eventually occurred. The Indonesian experience indicates that macroeconomic stability should never be taken for granted. Signs of vulnerability to financial instability include: the degree of reliance on gross private capital inflows (taking into account maturities and the implications for rollovers); the extent of unhedged foreign exchange positions; and certain indirect indicators, such as policy slippages and key personnel changes. Finally, in a world of volatile capital flows, crisis will tend to occur before standard economic data suggest that crisis is imminent.

Hmmm... Reliance on gross capital inflows...

by das monde on Fri Mar 23rd, 2007 at 02:18:57 AM EST
Sorry, the above post was supposed to be a reply to my own "Overheating" comment above.

I tried to google "overheating Minsky" together, but unambiguous relations are rare. It's a bit surprising that people interested in the same problem do not find each other's ideas easily.

One article cites an anonymous Waal Street economist:

what's going wrong is that economy is doing better than anyone expected it to do.

I think that many pyramid players had the same moment about their game. Sure, I immediately can raise a few obvious disclaimers, but...

Other NY analyst can say this:

When asset prices rise, it reflects a change in the money supply/asset relationship, meaning more money chasing the same number of assets. Thus when asset prices rise, it is not necessarily a healthy sign for the economy. It reflects a troublesome condition in which additional money is not creating correspondingly more assets. It is a fundamental self-deception for economists to view asset-price appreciation as economic growth. A housing bubble is an example of this.
by das monde on Fri Mar 23rd, 2007 at 02:35:42 AM EST
[ Parent ]

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