Friday, August 1, 2014

Minsky and the Nature of Instability

Minsky is an economist whose work has been overlooked. He is gaining popularity because of his thesis that stability, by its very nature, breeds instability. What starts an avalanche? It is like the camel's back, stable until it is not.
This is an excerpt from Minsky's paper on instability called "The Financial Instability Hypothesis" he wrote in 1992. He is discussing the basic tendencies of a stable economic system to become unstable. He describes three income-debt relationships for economic units he calls "hedge," "speculative," and "Ponzi." It is really a pretty simple thing, debt being as safe as the income stream behind it.

"Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle out of income cash flows. Such units need to “roll over” their liabilities: (e.g. issue new debt to meet commitments on maturing debt). Governments with floating debts, corporations with floating issues of commercial paper, and banks are typically hedge units.

For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts."

No comments: