What causes financial crises? | The Economist

This is a big question. For decades, however, economists rarely discussed it. True, there have been stock market bubbles and currency crashes, but central banks seem to have perfected their responses, preventing the emergence of systemic crises. Finance, a sub-discipline of economics, has focused on topics such as asset pricing. The carnage of 2008 changed that. Economists, investors and central bankers have returned to the big question. One answer, which had been crafted decades earlier but largely marginalized, received more attention than most: Hyman Minsky’s Financial Instability Hypothesis. Growing up during the Great Depression and serving on the board of a bank, seeing firsthand how risky a business could be, he was skeptical informed by the experience.

Beginning with a review of how companies pay for their investments, Mr. Minsky described three types of financing. The first, which he called cover financing, is the safest: companies can pay off their debts with their profits. They have limited loans and good profits. The second, speculative financing, is a bit riskier: companies can cover their interest payments but must roll over their principal. It works well normally, but not during a downturn. The third, Ponzi scheme, is the most dangerous. Income does not cover principal or interest; companies bet that their assets will appreciate. Otherwise, they are in trouble. Economies dominated by hedge finance – those with strong cash flows and low debt levels – are stable. When speculative finance and, in particular, Ponzi scheme becomes popular, economies are vulnerable. If asset values ​​fall, overburdened investors have to sell their positions. It hits asset values ​​even more, causing pain to even more investors, and so on – a downward spiral now sometimes referred to as “Minsky moment”. Investors would have been better off sticking to hedge financing. But over time, especially when the economy is healthy, the debt is overwhelming. When growth looks secure, why not borrow more? Banks add to the momentum, lowering their standards as longer booms last. If the defaults are minimal, why not lend more? Minsky’s conclusion is troubling: periods of stability breed financial fragility.

It’s a powerful idea, but what to do with it is another question. Over the years, mathematics has become the language of economics. Mr. Minsky’s narrative approach has left him outside the mainstream. Since 2008, academics have, with varying degrees of success, tried to bring more quantitative rigor to his hypothesis of instability. They showed how long periods of low volatility and high debt-to-cash flow ratios are indeed predictors of problems. For policymakers, the main takeaway from Mr Minsky is that constant vigilance is required, especially when things are going well. This helps explain the craze for macroprudential regulations in recent years: for example, banks’ capital requirements are now designed to tighten when they lend aggressively. But Mr. Minsky might also have predicted that as time goes by without a crisis, we will become more likely to forget his warnings.

Previously in this series
Monday: Akerlof lemon market
Tuesday: The Stolper-Samuelson Theorem
Wednesday: Nash’s Balance
Thursday: The Keynesian Multiplier

To come up
Saturday: The Mundell-Fleming Trilemma

In the last few weeks The Economist published two-page memoirs on six fundamental economic ideas. Read the full brief on Minsky’s moment, or click here to download a PDF containing all six articles.