Two Cheers for Minsky

The financial economist Hyman Minsky, who died in 1996, has acquired posthumous fame for his analysis of credit cycles, which provides a compelling account of the recent financial crisis from which we are still struggling to emerge.

Minsky argued that the growing euphoria of lenders during stable financial periods leads eventually to the extension of credit on terms that make it increasingly unlikely that debtors will be able to repay the loans. This leads to "Ponzi" credit, i.e., loans that depend on the debtors having to take out new loans to cover the debt service of old loans. This goes on until – as it did around 2008 -- excessive euphoria gives way to excessive pessimism, the tide of credit recedes and , as Warren Buffett might say, you find out who has been swimming naked.

Minsky deserves a resounding cheer for emphasizing the financial aspect of this kind of crisis. Looking back at the housing market of the 2000s, the explosion of sub-prime lending, and the bust circa 2008, we clearly see Minsky's "Ponzi" dynamic at work.

Minsky deserves another resounding cheer for perceiving clearly the irrational nature of financial decision-making during the business cycle, particularly during boom periods, which makes the whole financial and economic system unstable.This is what he calls his Financial Instability Hypothesis. It is surprising how difficult it is for economists like former Federal Reserve chairman Alan Greenspan, bewitched by the assumption of "rational expectations," to accept this obvious feature of the economy.

It was not always so. William McChesney Martin, who was the Federal Reserve chairman from 1951 to 1970, famously said it was the job of the Fed "to take away the punch bowl just as the party gets going." The image of Wall Streeters as tipsy party-goers needing adult supervision is a far cry from "rational expectations." It is, however, a plausible characterization of life in the fast lane in the mid-2000s.

But Minsky does not deserve a third cheer. His approach is too exclusively financial, and his theory of booms and busts lacks an adequate macroeconomic foundation. It is our contention in this blog that there is a fundamental imbalance in the economy these days. The income of the poor and middle classes is insufficient to purchase the goods and services produced by the investments, or intended investments, of the rich, whose saving exceeds the need for investment and leads to pressure on financial assets (like bundles of subprime mortgages).

Intended saving exceeds actual investment. But euphoria is still on the rise, and the banks are extending credit, sometimes foolishly. The credit markets look more and more like a massive Ponzi scheme. That is where Minsky comes in.