Minsky (2008) argues that financial crises are inherent in capitalist economies because economic prosperity breeds complacency toward risk-taking. This analysis is derived mostly from the banking sector, which seeks to maximize profit by offering loans to borrowers. Traditionally, banks use the deposits of customers to lend to borrowers. However, if asset prices rise, then banks have an incentive to take advantage of leverage in order to boost profits further. This leveraged lending scheme encourages asset prices to rise further and the expectations of investors and consumers adjust to those higher prices. Eventually, the system collapses when asset prices fail to rise further and when borrowers and the banks no longer have the liquidity to meet debt obligations. Assets are then liquidated and the supply of credit falls dramatically.

This story sounds familiar because we just witnessed something like it in the 2008 financial crisis. The asset bubble in that case was the housing stock and the parallels are astonishing. No wonder Minsky’s financial stability hypothesis has been revisited lately to provide insight into what happened in 2008 and how we should adjust financial regulation to deal with future financial crises.

However, Minsky’s hypothesis does not explain the 2008 financial crisis entirely. First, while there was an asset bubble in the real estate market leading up to 2008, the cause cannot be entirely due an exogenous rise in real estate prices. Buying homes during that period was incentivized by interest rates, which were as low as 1.56% (real) in 2004 due to Federal Reserve policy, which is about as low as interest rates are today (World Bank 2014). If the cost of borrowing is the lowest in recorded history, of course more borrowing will occur, which risks an asset price bubble. Thus, the bubble was not caused by capitalist speculation, but instead by central bank mismanagement.

Second, the problem in the financial crisis was not necessarily that housing prices were rising and subprime lending was abundant. The underlying issues are that lending institutions, not banks, failed to maintain adequate underwriting standards and that securitization of loans removed considerations of risk from the loan officer. Lending institutions, unlike banks, are not regulated. The largest subprime lender during the financial crisis was Countrywide Financial. As an unregulated lending institution, it was able to capitalize on hedged borrowing without accountability. Moreover, its ability to securitize loans and sell them off to investors inhibited the company’s ability to manage risk. Thus, it was not banks, as Minsky argues, that instigate leveraged financing, but it is instead profit-seeking institutions outside the purview of regulators.

Furthermore, Minsky’s hypothesis fails to explain other recent asset bubbles. For example, the dot-com bubble of 2000 was due to a misevaluation of the real value of technology companies. Speculative investing occurred and sentiments were high, but there were never threats of bank instability nor was there any reason to believe that banks took leveraging opportunities in order to seize the moment. Indeed, interest rates managed by the Federal Reserve again explain why leveraging did not occur during that bubble. The real interest rate was high at 7.19% during the years leading up to the bubble (World Bank 2014). Banks would have had to have been exceedingly optimistic to borrow at that rate and still seek to profit from the dot-com bubble.

Lastly, Shiller (2003) shows evidence that asset bubbles occur all the time, but these asset bubbles do not always lead to financial crises. Shiller estimates that as many as 40 asset bubbles occur every year. The reason why we don’t notice them is because they are relatively small and segmented. It is only the very large asset bubbles that we notice. Minsky’s hypothesis has a limitation that it never specifies how large of an asset bubble is required to lead to financial crises. At what moment does an asset’s price instigate hedged borrowing, speculative finance, or Ponzi finance? His hypothesis therefore assumes that there will always be an asset bubble large enough to distort financial markets in a capitalist economy due to complacency. If bubbles occur regularly and the pain from busts also occur regularly, then what room does a capitalist society have for complacency?

In spite of these criticisms, it is important to remember that Minsky’s hypothesis is a model. As all models, it relies on assumptions that simplify the real world. The financial fragility hypothesis does contribute to how we ought to think of financial crises and financial regulations. But it is important to remember that the hypothesis is not perfect, and policies borne out of the hypothesis should be aware of its limitations.

Thomas Wong works at the Office of the Comptroller of the Currency and is a graduate student in economics at American University. He writes on public policy and economic issues.

Minsky, Hyman. Stabilizing and Unstable Economy. McGraw-Hill. 2008.

Shiller, Robert. “From Efficient Markets Theory to Behavioral Finance.” Journal of Economic Perspectives. 2003.

World Bank Database. 2014. Accessed through Google Data.