Minsky's Theory of Financial Crises in a Global Context
Wolfson, Martin H., Journal of Economic Issues
Hyman Minsky's theory of financial crises was developed in the context of a domestic economy. Recent financial instability in the international economy, however, suggests that it would be useful to examine his theory in a more global environment. After briefly discussing the main themes of Minsky's domestic theory in the first section, this paper then attempts to identify how the theory would need to be modified to take account of the international setting. In the last section, institutional changes in the global economy are investigated and their relevance to financial crises is evaluated in light of the theory discussed in the second section.
Main Themes of Minsky's Domestic Theory of Financial Crises
For our purposes here, we will consider Minsky's theory under the following headings: the systemic development of financial fragility; the movement to the brink of financial crisis; the disruption of stability by a "not unusual" (surprise) event; and debt-deflation, including the ability to prevent the debt-deflation process.
The Systemic Development of Financial Fragility
Minsky's theory of financial crises is set within the context of an expanding economy. As the expansion develops, optimism increases, and conventions about the proper level of debt and risk begin to change. Prices of financial assets rise and the general level of speculation increases. Speculation is taken to be the attempt to bet on the future direction and psychology of the market (Keynes 1936, 158), and also the more general process of financing assets whose value depends on future developments (Minsky 1975, 120-23).
As attitudes about risk and proper liability structures change, the financial system becomes increasingly fragile. Minsky's view is that fragility grows as debt levels increase, the proportion of short-term debt rises, liquidity declines, and speculative and Ponzi firms (see below) increase (Minsky 1977, 142). The proportion of short-term debt increases as firms take advantage of a normal yield curve, in which long-term interest rates are higher than short-term rates. "With such a rate pattern, one can make on the carry by financing positions ... in long-term financial assets by short-term, presumably liquid, debts" (Minsky 1986, 211).
The terms hedge, speculative, and Ponzi finance are used to indicate the relative difficulties that economic units have in repaying debt. The classifications revolve around the relationship between cash receipts due to normal operations and cash payment liabilities due to debt. A hedge firm is able to meet all cash payment liabilities with cash receipts. A speculative firm, however, has difficulty meeting some payment liabilities, usually those coming due in the short term. Typically, a speculative firm will have to refinance some short-term liabilities. A Ponzi firm has the most difficulties; it must borrow to meet current interest payments. Thus a Ponzi firm is continually increasing its outstanding debt.
The Movement to the Brink of Financial Crisis
Minsky argued that there would be a tendency for speculative and Ponzi units to increase, in relation to hedge units, with an increase in interest rates: "speculative and Ponzi-finance units are vulnerable to changes in interest rates ... increases in interest rates will raise cash-flow commitments without increasing prospective receipts" (Minsky 1986, 209). The Federal Reserve, by increasing interest rates in the context of tightening monetary policy, has thus been in the position of actually worsening financial conditions: 'The Federal Reserve can bring a halt to an inflationary process only as it forces high enough interest rates so that units which need refinancing are found to be ineligible for financing ... Since the mid-1960s the Federal Reserve has been able to force a contraction only as it has taken the economy to the brink of financial crisis" (Minsky 1982, 199). …