Fallen on Deaf Ears: How One Economist’s ‘Fringe Theory’ Accurately Predicted the Current State of the Economy
Few like to hear these words: “I told you so!” However, that will be the theme of this article. Not because we warned you of an imminent recession and credit crisis but because a man named Hyman Minsky did. If you have ever been in an introductory economics course or feel like you have a basic understanding of the concept of supply and demand then you are somewhat familiar with the notion of an equilibriating economy. That is, an economy that is constantly at or reverting to a state of equilibrium. Indeed our modern economic models employed by central banks are based upon this idea. We are constantly trying to get our economy back to natural unemployment, inflation, GDP growth, etc. What if our economy was disequilibriating? What if the financial system itself was driving the booms and busts? While this classical framework seems to neatly explain our incredibly convoluted national and global economy it has one fatal flaw.
But before we dive into that flaw, we have to discuss who this Minsky guy is. Hyram Minsky was an American economist and professor at the Washington University in St. Louis. He was a post-keynesian who researched the ways in which the financial industry led to volatile swings in the economy and was amongst the first to provide explanations for financial crises. His theories were summarized in his “Financial Instability Hypothesis” (FIH) but they were met with heavy criticism leading to his work largely being ignored by mainstream economists. While his peers were also post-keynesians, they rejected his interpretation of Keynes’ General Theory. Unfortunately, he died in 1996 before many, including Janet Yellen, began to recognize the validity and relevance of his work following the 2008 financial crisis. So whats the point of this article? Everyone already recognized his theories as legitimate so just link us to his work so we can learn how economic policy has embraced his work in the past decade, right? Wrong. The point of this article is to show how we’ve learned nothing and what Minsky predicted is happening all over again.
So what was that fatal flaw we mentioned earlier? What could be wrong with the standard interpretation of Keynes and equilibrium models of the economy? Well, these economic paradigms simply do not account for endogenous shocks that send economies into recessionary periods. Rather, they rely on exogenous shocks such as oil price crashes, pandemics, or wars to show how the economy can be knocked off course. In simpler terms, they imply that the economy can’t kill itself, only outside events can do this. This is a big problem because as you already know, the 2008 crisis was entirely self-made in the financial system and was not the result of some catastrophic external event. Minsky simply identified that American’s have a tendency to screw themselves on their own and this also true of the financial industry. Come on, we have world leading heart disease and diabetes rates due to the standard American diet and we literally kill eachother with our loose gun control so its not a stretch to believe that our financiers are also hell bent on pushing us to economic collapse.
In principle, Minsky’s Financial Instability Hypothesis is simple. He was a mathematician but preferred to present economic theory as a narrative rather than with complex equations. What was the basic idea behind his hypothesis in three words? “Stability breeds instability” He posited that as the economy grew, so would complacency and in turn lending standards would degrade. This leads to runaway levels of debt in the economy far outpacing the growth rate of Real GDP ultimately leading to what is termed a Minsky moment where creditors realize how unsustainable this lending is and liquidity dries up. The ensuing credit crisis then reverberates throughout the entire economy leading to a recession. A typical example of this cycle is shown above.
Looking at the economy from a Wall Street board room, we see a paper world — a world of comitments to pay cash today and in the future. These cash flows are a legacy of past contracts in which money today — was exchanged for money in the future. — Hyram Minsky
If Revenue - Expenses ≥ Interest Payments != True, then Bad Things Happen
Minsky claimed that there would be three stages of lending in the run-up to the inevitable tipping point. They are: hedge lending, speculative borrowing, and Ponzi borrowing. It all begins with bank lending that is secured against assets (hedge lending). Businesses with high cash flows that are stable which then take out a loan would fit this definition. Then, as the economy grows, lenders and borrowers become increasingly optimistic and go on to take on greater risks. Banks require lower covenants from businesses and become more willing to lend larger multiples of business income. Lending of course becomes more leveraged.
This is when you see speculative borrowers enter. These borrowers do not believe their future cash flows can cover debt interest payments but they presently can. However, they can only pay down the interest on this debt and not principal. Therefore, they rely on the ability to refinance down the road at lower interest rates. Carrying on, this increased lending leads asset prices to rise. I repeat the LENDING causes asset prices to rise and NOT genuine growth in the real economy. People keep expecting rising prices and the past becomes the guide to the future.
This is when irrational exuberance starts to set in. Finally, we see Ponzi borrowing. Ponzi borrowing is when a borrower takes out debt on an asset but has no cash flow to pay off the debt at all so the borrower solely relies on the asset value increasing to be able to service debt payments. Meanwhile regulators are also caught up in the innapropriate optimism and credit rating agencies pave the way for more of this risky borrowing. Of course this is unsustainable but there will be a belief that this can go on for ever as there was in 2008 and there is now. Then the bubble pops and lenders, borrowers, and regulators are all caught with their pants down while workers and savers are called on to foot the bill.
An economy with private debts is especially vulnerable to changes in the pace of investment, for investment determines both aggregate demand and the viability of debt structures. The instability that such an economy exhibits follows from the subjective nature of expectations about the future course of investment, as well as the subjective determination by bankers and their business clients of the appropriate liability strucuture for the financing of positions in different types of capital assets. — Hyram Minsky
If we haven’t moved Minsky into the top 5 dead people you’d have a coffee with if you could, then hopefully an analysis of how FIH has been consistent with the happenings of the post-2008 expansion will. Lets start with this chart for example. See any similarities to the archetypal example shown earlier? If you guessed that corporate debt is way above our Real GDP growth rate then you are correct. This is exactly what Minsky warned us about. An endogenous bubble driven by irrational exuberance of the financial system. Why is there only a small, marginalized voice decrying this? Because we simply do not teach this stuff. Econ majors graduating today have no idea what FIH is or how endogenous shocks stemming from the financial system affect our economy. Therefore they are oblivious to this happening despite us already experiencing this in 2008 with risky subprime loans being repackaged into Mortgage Backed Securities. Sure, mortgages aren’t the issue this time around but risky lending still is. Its just coming in the form of private credit and corporate debt.
So now the skeptics might be saying, “Sure, we have record levels of debt but the quality of debt isn’t deteriorating like Minsky said it would. There aren’t any Ponzi or even speculative borrowers out there. Stop fear-mongering.” To which we reply, the only way we know how: graphs.
Now we know that was a lot of charts but there’s no need to panic…before you’ve read them at least. The first chart speaks to Minsky’s hypothesis of lenders becoming more lax and requiring less collateral in the form of covenants to give out loans. Covenants being rules that corporate borrowers must follow such as keeping a certain proportion of the value of the debt in reserve. However, covenant-lite bonds have little to none of this protection because lenders feel comfortable taking on the risk. Chart 4 also shows the utter decline of covenants according to Moody’s, one of the big three ratings agencies.
Chart 3 also shows the the spectacular growth of leveraged loans along with Chart 5 and Chart 6. Leveraged loans are credit extended to borrowers with already large debt loads and poor credit scores. From the lens of Minsky, these loans represent speculative and Ponzi borrowers. These types of loans have been growing at a terrifying pace suggesting that the “irrational exuberance” has gotten out of hand. These borrowers depend on the ability to refinance and rising asset prices. Finally, Chart 7 shows that a huge debt repayment wall is here for 2020. Should a black swan event come and strike fear into the hearts of lenders leading to a liquidity freeze then god help us all…
Oh wait, we’re sandwiched between a global pandemic and and oil-price war. Both of which have exposed serious cracks in the liquidity system. Needless to say we are watching the situation closely.
In any case, we believe that Hyram Minsky’s work is essential to understanding our modern economy and should be required reading for all budding economists and finance enthusiasts alike. His insights have proven to be accuarate not only in the last crisis but also in the one we will soon face. If you’d like to dive deeper into his Financial Instability Hypothesis, this is a good place to start.
In 380 B.C. the Philosopher Plato published his landmark work: The Republic. In it he presented the Allegory of the Cave, which he used to explain the issue of truth and deception in his society and his ideas ring true to this day. We at Plato’s Cave believe that the overwhelming majority of the world’s population is trapped in the metaphorical cave of fake news, bent truths, and flat out lies fed to them by the financial world. It is our intention to liberate the masses from financial illiteracy and falsehoods and guide them out of the cave into the light of truth, one article at a time.
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