Minsky “Financial Instability Hypothesis” Essay Example

big government. The final is a brief conclusion.

Section 1: Structural elements: a first look at Minsky’s ‘Financial instability hypothesis’ Financial innovation in two decades: the new financing market Three key developments in financial markets over the past two decades have gradually dismantled the gaps within financial markets and have raised its efficiency. But they have also greatly raised the potential for financial instability and following the threats of crisis (Edey, 1996). Firstly, the process of globalization of financial service industries and the increased volume of the international capital flows have led in a striking increase of international financial transactions.

The modern financial market provide both across borders and across market sectors in financial shocks business. For evidence, at the end of 1994, the stock of cross-border bank assets had increased more than 4. 5 times comparing its situation in 1983. Further, the assets have rise from 20% of the GDP of OECD countries in 1980 to 35% in 1994. However, the effects of globalization process in financial markets are evidently beyond the scope of this article (Edey, 1996).

Secondly, widespread functional integration of banking and securities business has led to the operation combination between financial conglomerates and traditional banks and non-bank business, therefore leading a fusion of commercial and investment banking. The increasing tendency for the fusion is highly resulted from the deregulation policies in major financial centres including London, the United States and Japan. The motivation of the deregulation in those countries is that financial institutions, commercial business and government believe it is profitable through the integration (Edey, 1996).

Thirdly, financial innovation, particularly in the derivative products, has produced

a new financial market which did not exist two decades ago. One of the most important factors is the widespread computer users and therefore the ease and cheapness of processing information could encourage a number of innovations in financial system, particularly in the rapid increase in derivative products including futures, option, swaps, and related hedging instruments (Edey, 1996).

Section 2: income-debt flow analysis: a first look at Minsky’s “Financial Instability Hypothesis”

Minsky focused on economic boom-bust cycle in the long run, arguing capitalist economy has inherent instability. He agreeed the role of investment in economy from Keynes and highlighted the significance of financing investment in economy, stating the economic instability is highly resulted from financial instability. He concluded that except the capital assets and labour force characteristics, financial relations also link the past, present, and the future capitalist economy (Minsky, 1992).

In the begining, Minsky uses Kalechi-Levy view of profits which saying aggregate demands determines profits. In the highly simplified model, profit is from incomes and wages, aggregate profits equal aggregate investment. In a more complex model, aggregate profits equal aggregate investments plus government deficits. In Keynes “veil of money” world, businessmen invest current capital and cash (present money) because they expect future profits (future money) to take place in the future, and the rapid increase of the money flow takes place due to the highly cooperative bankers role (Minsky, 1992).

Bank plays a central role in this transformation between present money and future money. Money flows from households to bank, from bank to firms, and from bank to households again. Therefore, the financial instability hypothesis is building on the role

of debt in financial behaviour system. As the invest expansion behaviour develops, optimistic expectation increase, the attitudes about proper level of debt and risk change, then financial system becomes increasingly fragile (Minsky, 1992). Indeed, money flows in modern financial system is getting even more valid and complex.

Households could borrow money from banks by credit cards for big purchase such as houses and cars. Furthermore, governments entered into financial system by their large floating and funded debts and their refinancing agents among financial institutions. In addition, the globalization process makes an increase in the cross-board and cross financial markets financing business (Minsky, 1992).

According to Minsky’s insights, this paper believes the crisis exist because the present financial market is overvalued due to its rapid expansion irrational expectations and speculations. Minsky’s theory of financial crises is building on an increasingly expanding economy. As the expansion develops, actors in financial market raise their expectation of future money and change their ideas of debt and risk design, and they increase their level of speculation therefore Ponzi forms increase (Wolfson, 2002).

Minsky identified three distinct income-debt relations, including hedge, speculative and Ponzi finance according to their different ability to repay debt. Their ability is defined by the balance between cash receipts and cash payment. A hedge financing firms is able repay all debts. A speculative firm has difficulty to meet all cash payments. Speculative units need to refinance their short-term liabilities. For a Ponzi firm, its cash flow from operations has the most difficulty to meet the repayment of liabilities or the short-term interests.

Usually the Ponzi firm could sell assets or borrow more to

pay the interests, which makes it under a more dangerous situation because it has to fulfill more payments in the future and leads to a collapse of asset values. The greater the weights of speculative and Ponzi units in the financial market, the greater the possibility that the crisis could occur (Minsky, 1992). Minsky argued that there is the tendency for speculative and Ponzi finance to rise which has been evidently proved in modern financial markets.

Some argues that the Federal Reserve Bank could increase interest rates to tight the monetary policy. However, it actually makes the condition worse. “Speculative and Ponzi units are hardly to repay the debts due to the changes in interest rates. Instead, the rise in interest rates will raise cash flow commitments” (Minsky, 1982: 209). In a fragile financial market, Minsky views that a “not unusual” (surprise) event is able to initiate a financial crisis and spread to other markets rapidly due to increasing cross-board financial transactions and business (Altman & Samets, 1977: 140).

What is also necessary for the spread of financial crisis is a lack of government intervention and highly open financial investment market in domestic. Minsky continually developed his financial instability hypothesis to incorporate the extensions made to his investment theory over the course of the 1960s, 1970s, and 1980s. The Kalecki equation was added; the two-price system was incorporated; and a more complex treatment of sectoral balances was included. Minsky also continued to improve his approach to banks, recognizing the futility of Fed attempts to control the money supply.

He argued that while the Fed had been created to act as lender of

last resort, making business paper liquid, the Fed no longer discounted paper. Indeed, most reserves supplied by the Fed come through open market operations, which greatly restricts the Fed’s ability to ensure safety and soundness of the system by deciding which collateral to accept, and by taking a close look at balance sheets of borrowers. Instead, the Fed had come to rely on Friedman’s simplistic monetarist view that the primary role of the Fed is to “control” the money supply and thereby the economy as a whole—something it cannot do.

The problem is that attempts to constrain reserves only induce bank practices that ultimately require lender of last resort interventions and even bail-outs that validate riskier practices. (p. 94) Together with countercyclical deficits to maintain demand, this not only prevent deep recession, but also create a chronic inflation bias.

The Keynesian and Marxian insights on nationalizing and financial industry are also helpful (Palley, 2010). Section 5: A Big bank or A Big Government: Minsky response to financial crisis In Minsky’s perspective, He highlighted the actual path an economy traverses depended upon the liquidity of the economy, the lender of last resort action by the big bank, the efficient government policies in stimulating aggregate demand. On the one hand, one intervention that helps to restrain the debt-deflation process is a big bank.

One reason of the spread of financial crisis cross borders is interest rates. In the Asian financial crisis, the striking increase of interest rates in Japan was one significant factor to make the situation worsen because profits is lower for those who borrowed in Japan due to its low interest rates,

making their repayment harder (Wolfson, 2002; Minsky, 1992). Furthermore, changes in exchange rates can also threaten businessmen’s profits. If one borrow a loan which was made in hard currency such as the U. S. dollar, then a fall in domestic currency against the U.

S. dollar will diminish investors’ profits in other countries (Wolfson, 2002). Minsky, argues if there is one central bank (which he called a big bank) to play a role as a lender of last resort, it will be efficient to control financial crisis. However, in Asia countries, there are some obstacles to have a central bank cross boarder. Although Asian central banks could act as a lender of last resort in their domestic, there is no one global level big bank for those have the need to repay loans in hard currency (Wolfson, 2002; Minsky, 1986).

On the other hand, In Minsky’s theory, the big government is the other way restrain crisis by imposing macroeconomic policy to increase aggregate demand. A big government means a federal government that weights nearHe stated a big government capitalism could offer a more stable economy which could also deal with the unfair distribution and unemployment. But he also noted strong interventionalso tends to create inflationary and moral hazard.

In conclusion, this study argues “financial instability Hypothesis” provides an argument how a capitalist economy inherently generates a financial system and inherently responsible for the financial crisis even with normal operations. Minsky added the “financial theory of investment” to the Keynes’ “investment theory of the cycle”. He concluded that except the capital assets and labour force characteristics, financial relations also link the past, present,

and the future capitalist economy (Minsky, 1992).