Arguably one of the most important events of the 21st century was the 2008 Great Recession, caused by unsustainable debt in the housing markets that was brought upon by risky lending and the creation of mortgage bonds, among other things. In the blockbuster film The Big Short, originally a novel by Michael Lewis about the 2008 crisis, Christian Bale’s character Michael Burry is attempting to explain to a potential investor that the housing bubble is about to pop. The investor replies, “No one can see a bubble, that’s what makes it a bubble”. During the financial crisis that followed, the saying, “Hindsight is 20/20” was extremely applicable. The late economist Hyman Minsky, who for the majority of his life remained a relatively unknown post-Keynesian economist, theorized about why financial crises occur, particularly in his Financial Instability Hypothesis. His main argument was that financial market stability in a capitalist society would lead to a sense of euphoria about market conditions that ultimately led to financial market fragility.
When attempting to understand why capitalistic markets see such robust upturns and downturns, it is important to understand how capitalism operates at its most fundamental level. Capitalism is a system of private ownership of capital (real estate, technology, ideas, ect) that operates in a relatively free market with little restrictions. The system today relies on a complex and interconnected financial market where financial intermediaries facilitate investment by helping distribute debt and equity to firms that they believe will create future profits. However, debt must be repaid and in the case of the 2008 financial crisis, people borrowed at unsustainable levels. In the years leading up to the financial crisis, housing and other asset prices were soaring which led to a fury of borrowing. Banks and consumers alike became highly leveraged to get in on the action based on speculation that the market would continue its upward trend. Sub-prime borrowers began borrowing to buy homes they could not afford and once the massive influx of mortgage defaults occurred, people began short selling so called “riskless” mortgage backed securities. This had a domino effect on banks and financial institutions who were heavily involved in sub-prime lending. Their collapses trickled into the rest of the economy, plummeting asset prices around the world.
Hyman Minsky believed there are, “three distinct income-debt relations for economic units, which are labeled as hedge, speculative and Ponzi finance”. He believed that an economy dominated by hedged financial units would lead to equilibrium price clearing in the economy and overall economic stability. However, as people become more confident in the economy, the economy will begin to be dominated by speculative financial units due to financial institutions confidence in future profits of borrowers. He predicted this would lead to unwarranted inflation and extreme borrowing, captured by Ponzi financial units. These are financial units where “cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debt”. He said this would, “likely lead to a collapse of asset values”.
I believe Minsky’s theory about the nature of business cycles may be one of the most important and accurate. With the United States government 19 trillion dollars in debt and China on the brink of a housing bubble, it may be time for politicians and economists to start taking a closer look at Minsky’s theory and the future nature of debt financing.