Financial Fragility and the
Lender of Last Resort
Business cycles engender financial instability as part of the recessionary adjustment to overproduction. This cyclical phenomenon must be distinguished from financial fragility, a gradual build-up of structural imbalances in the credit system which is part of the long-wave dynamic of the economy (see sections 3.1 and 3.2). During an expansion phase both borrowers and lenders will become more risk-prone and will accept higher debt levels when they see earlier investment decisions successfully validated. The usually short and shallow recessions during that phase are too weak to force much of a retrenchment in this debtdriven expansion. Gradually rising indebtedness is one major reason why the boom eventually ends (see Minsky, 1964).
Once the long wave turns down, the credit system typically experiences continued deterioration. Since finance capital is tied to industrial capital (see section 2.3), it will naturally experience losses when profit-rates suffer a sustained decline. The combination of slowing income gains and rising debt-servicing charges makes heavily leveraged borrowers vulnerable to loan defaults. Bad-debt losses in turn threaten the solvency of many lenders. These trends usually become more pronounced as the downswing phase persists. It is then, after such financial fragility has built up for a decade or more, that recessionary adjustments to overproduction have typically disintegrated into depressions in the past. See, for example, the deepening financial crises between 1873 and 1896 or the growing number of bank failures during the 1920s that led to the catastrophic collapse of the entire credit system between 1929 and 1933 (see chapter 4).
The latest downswing phase has been no exception to this pattern. In 1966 profit-rates reached their postwar peak and began a long-term decline. U.S. industry came to rely on more debt financing to cover a rapidly growing financing gap. That jump in corporate borrowing needs coincided with the shift to "liability management" by banks whose use of borrowed liabilities allowed