Lecture 4
A Perspective on Minsky Moments: a
Revisitation of the Core of The Financial
Instability Hypothesis
Alessandro Vercelli
Department of Economic Policy, Finance and Development (DEPFID)
University of Siena
Presentation based on:
1) Vercelli, A., 2009a, A Perspective on Minsky Moments: The Core of the Financial
Instability Hypothesis in Light of the Subprime Crisis,
Levy Working Paper, n. 579, The Levy Economics Institute of Bard College,
Annandale-on-Hudson, NY,
A perspective on Minsky moments: Revisiting the Core of the Financial
Instability Hypothesis, in Review of Political Economy, vol.23(1), 2011, pp.4967.
2) Vercelli, A., 2009b, Minsky Moments, Russell Chickens, and Gray Swans: The
Methodological Puzzles of the Financial Instability Analysis,
Levy Working Paper n. 582, The Levy Economics Institute of Bard College,
Annandale-on-Hudson, NY;
in Tavasci, D. and J. Toporowski, eds., 2010, Minsky Crisis and Development, Palgrave
Macmillan, Basingstoke and New York.
Reflexions on the FIH in the light of the subprime crisis→ restatement
1) analytic and policy issues
Twin papers {
2) methodological aspects
Purposes of the presentation
- In the first part I will provide a definition of Minsky moment
based on a simple model of financial fluctuations that restates the core of
the Financial Instability Hypothesis in the light of the subprime crisis
- In the second part I use this model to interpret the subprime crisis
- In the third part I draw a few policy implications from the above analysis
Minsky moments
Since the beginning of the ongoing financial crisis → revival of interest in
Minsky’s work by academics, practitioners and mass media
Surprising: his “financial instability hypothesis” had been harshly rejected by
classical camp (monetarism, NCEcs)
mainstream economists {
Keynesian camp (neoclassical synthesis, NKEcs)
insulted: demagogue, lugubrious, obscure, vague, and so on
no teaching on Minsky, difficult to publish on Minsky, and so on
Minsky moments
Minsky moments: exceptional circumstances of severe financial crisis
Expression coined in 1998 in occasion of the Russian debt crisis by
Paul McCulley manager of bond funds PIMCO, investment co that
runs the largest bond Fund
→ fashionable catch phrase during the subprime crisis, adopted by
• top-level practitioners and analysts (such as Magnus, senior
economic adviser at UBS Investment Bank: articles on the FT)
• leading financial journalists (such as Martin Wolf. Financial Times;
Lahart, Wall Street Journal; Cassidy, The New Yorker)
• academic economists (such as Whalen, 2008; Wray, 2008; Davidson
2008, Bellofiore and Halevi, 2009, etc.)
Definitions of Minsky moments
•
as a point of time (consistently with the usual meaning of “moment”):
Magnus (2007, FT): “the point where credit supply starts to dry up”,
Wolf (2008, FT): “the point at which a financial mania turns into panic”
•
as a process (short-lived relatively to the periods of financial tranquillity):
McCulley (2001, pimco.com): “a self-feeding process of debt-deflation”
Lahart (2007, WSJ): “when over-indebted investors are forced to sell even
their solid investments”
Magnus (2007, FT): “when lenders become increasingly cautious”,
Whalen (2008): “credit crunch or Minsky moment”,
Davidson (2008): “when the Ponzi pyramid financial scheme collapses”
different aspects of a Minsky process
consistent {
Minsky moment as starting point of a Minsky process
Minsky moment and Minsky process
Minsky moment
To avoid confusion we prefer to distinguish {
Minsky process
→ Minsky process as a well-defined phase of a financial cycle
→ we need a model of the financial cycle to analyze this phase
only the “core”: the strict financial part
Revisitation of the FIH {
updated and somewhat developed
I intend to argue that the moment of Minsky should not be confined
to Minsky moments
Minsky meltdown
Minsky meltdown: terminology borrowed by nuclear reactor engineering:
extremely rare event involving high risks (“Once in a century”: Greenspan)
Definitions:
-McCulley, quoted in Lahart, WSJ, 2007: ”a spreading decline in asset values capable of
producing a recession”
-G. Magnus, FT, 14.10.2008: ”the point where financial instability has become so acute
that only an exceptional, immediate and global government attack on the causes of
instability is likely to avert a systemic banking failure in which non-financial
companies could rapidly fail too”
-Whalen, 2008: “without intervention in the form of collective action, usually by the
central bank, the Minsky moment can engender a meltdown, involving asset values
that plummet from forced selling and credit that dries up to the point where
investment and output fall and unemployment rises sharply”
Minsky moment
Difference between
{
is a matter of degree
Minsky meltdown
Minsky meltdown: when the Minsky process is so intense to trigger a
recession
Why Minsky now?
•
Instrumental use: to justify policies in blatant contradiction with orthodoxy
•
Protective belt around orthodoxy: distinction between rule and exceptions
exceptions: very low probability (Greenspan: “once in a century”)
In this view{
“exceptions confirm the rule”
orthodox theory for the rule
Thus
{
Keynes: theory of depressions
heterodox theory for the exceptions {
Minsky: th. of financial crises
Instrumental use of Minsky
Reference to Minsky moments and meltdown as the only possible theoretical
endorsement for a policy in contradiction with neoliberal doctrines
For example, after illustration of emergency bail-out plans in the USA, the UK,
and EU, G. Magnus (FT, 14.10.2008) :
“This comprehensive assault on financial instability is the only solution
that Minsky himself would have approved”
However, Minsky would not have approved the policies implemented before
and during the ongoing (and preceding) financial crises: destabilizing
stabilizations
in order to “stabilize an unstable economy” we need structural
interventions that prevent the crises and thwart them before the first
symptoms emerge; in any case priority to full employment
Mainstream regularism
Mainstream economics is based on a principle of regularity
→ the most influential version is that of Lucas :
economics as a science has to be based and applied only to
economic regularities (stationary stochastic processes)
(Lucas, 1976, 1981)
→ this justifies in this view equilibrium, stability, substantive
rationality, RE, stationarity, weak uncertainty, and so on
Why regularism is flawed
• The “exception” may be the most important “moment” (Russell)
”The man who has fed the chicken every day at last wrings its neck instead,
showing that more refined views as to the uniformity of nature would have
been useful to the chicken”
(The Problems of Philosophy, 1912, chap IV, On induction)
→ a more refined view has to encompass the relevant exceptions
• The analogy of the “black swan” (Taleb) is misleading:
the crisis is a recurrent exception not independent of the rule
→ the crisis is rather a “grey swan” periodically reappearing
(young swans are grey!: color determined by the life cycle)
Lucas’s economic regularities
Lucas admits that economic phenomena may be sometime irregular
however, they cannot be analyzed by economic science
→ the most important example is the Great Depression:
he claims that the more distant in the past it gets, the smaller
becomes its statistical weight in long-term regularities
therefore, we are justified to ignore this and other exceptions
The success of this approach has contributed to the financial crisis
by justifying a declining perception of risk
A broader perspective
We cannot understand and deal properly with a financial crisis if we
exclude the relevance of exceptions (disequilibrium, instability, etc)
→ we need a more general vision: both regular and irregular phenomena
Keynes
We have to draw inspiration from authors such as
{
Minsky
not because they are theorists of the exceptions but because:
accounts also for the exceptions
their broader perspective{
clarifies the relation between rule and exceptions
in an open world we have to continuously update and develop their theories
The parable of Russel’s chicken
«In the animals farm (where each animal speaks and reasons as an Homo
economicus) there was a flock of rational chickens (rational in the sense
of Lucas) that were happy to run to the farmer every morning to be fed
Only one eccentric chicken noticed that older chickens had periodically
disappeared and expressed the fear that the benevolent farmer was
fatting them to bring them to the slaughterhouse
The other chickens didn’t take him seriously: they claimed that he was a
lugubrious troublemaker and that if some chickens had disappeared this
depended on the fox
however the farmer had already promised to raise and strengthen the fence
That night the eccentric chicken escaped from the farm before a stronger
fence would prevent it and saved himself: the following morning all the
other chickens were put on a lorry and brought to the slaughterhouse»
The parable of Russel’s chickens
Moral: the rational chickens behaved according to a “science” based
on empirical regularities (the farmer fed them all the mornings):
their science was apparently wrong only in a particular morning but
that moment was the most important one
The eccentric chicken saved himself because he had a more general
point of view than “rational” chickens: the trouble is that in a
globalized world we cannot escape beyond the fence
→ we need a more general vision but we have also to change the world
Minsky’s implicit theorizing
Victim of many unjustified criticisms; one to be taken seriously is:
Implicit theorizing : axioms are not made explicit, arguments are not fully
rigorous, models are insufficiently formalized
(in particular by Tobin; after Leontiev against Keynes)
This is the hallmark of original theories (in all scientific disciplines) theorizing
is made explicit only through the work of generations of followers
standard theory has been developed/refined by generations of scholars
→ if the Minsky’s view of financial fluctuations is more general and
realistic and may save us from Minsky’s moments and financial meltdowns
we should invest in its development/refinement
what follows aims to go in this direction
The core of FIH: a restatement
Minsky starts his numerous versions of the FIH from a
classification of economic units from the point of view of
their financial conditions
hedge
Financial units {
speculative
non-hedge {
Ponzi
Distinction hedge/non hedge
mt = yt - et
mt* =
mt
current excess (or net) financial inflows
sum of discounted expected net inflows: net worth of the unit
index of liquidity
mt*
mt > 0 for every t
hedge
{
index of solvency
mt < 0 for some (not all) t
non-hedge {
mt* > 0
mt* > 0
Distinction speculative/Ponzi
a) Different time profile of net inflows (n is the time horizon):
mt < 0
for: t < s <n (s small), mt > 0
for: s < t ≤ n
speculative {
mt* > 0
mt < 0
Ponzi
for: t ≤ n -1,
mt >> 0 (big) for: t = n
{
mt* > 0
b) different gravity and urgency of liquidity problems:
-speculative can repay maturing interests but not the principal in some t
-Ponzi cannot repay even the maturing interest in all t but the last one
Constructive criticism
The use of this taxonomy by Minsky is full of illuminating qualitative
details (accounting, institutional, historical details, and so on)
However, the way in which he formalized it is wanting:
obstacle to a further development of the FIH in applied research
hedge
qualitative taxonomy { speculative
Ponzi
unfit for quantitative analysis {
qualitative attributes ambiguous
such as s small and surplus >>
A further category: distressed units
We should consider a further category of financial units:
units in financial distress
Distressed units virtually insolvent: net worth mt* negative
In the past two years many banks and financial institutions had to be
classified in this way, and –to some extent- this is always true in financial
crises: particularly important object of analysis
Minsky did not consider them in a systematic way, probably because they
are by definition virtually insolvent and then unsustainable units
however this does not mean actual insolvency → they may be bailed out
by the state, by other units, or by means of a radical restructuring
even according to Minsky the net worth of a Ponzi unit is negative for “any
honest computation of present value” (Minsky 1977 c)
A suggested classification of financial units
Each financial unit is characterized by a pair of values: kt and kt* that
define its liquidity and solvency situation at time t:
continuum of values in a 2-dimensional space
-allow a representation in a Cartesian diagram
in order to {
-while keeping in touch with their intuitive meaning
I restate the two indexes as ratios:
liquidity ratio: excess (or net) financial outflows
kit = eit / yit
n
solvency ratio: net worth of the unit k
i it 
*
 E  e  / 1  r 
s 0
n
s
it  s
 E  y  / 1  r 
s 0
it  s
s
Classification of financial units
k
speculative and Ponzi
highly
distressed
1
hedge
distressed
1
k*
Table 1: Relationship between Minsky’s and this paper’s taxonomies:
rules of translation
Minsky
mit = yit – eit
Financial units
n
m 
*
it
Hedge unit
mit > 0,
E (mit) > 0
mit* > 0,
Speculative unit
Ponzi unit
s 0
E  mit  s 
1  r 
s
t=0
1≤t≤n
1≤t≤n
kit* 
This paper
kit = eit / yit
n
s
 E  eit  s  / 1  r 
s 0
n
 E y
s 0
it  s
 / 1  r 
kit < 1,
E (kit) < 1
t=0
1≤t≤n
kit*< 1,
1≤t≤n
s
mit < 0,
E (mit) < 0,
E (mit) > 0,
t=0
t < s < n, s small
s≤t≤n
kit > 1,
E (kit) > 1
E (kit) < 1
t=0
t < s < n, s small
s≤t≤n
mit* > 0
1≤t≤n
kit* < 1
1≤t≤n
mit < 0,
E (mit) < 0
E (mit) >> 0
mit* < 0 ,
t=0
1 ≤ t ≤ n-1
t=n
1 ≤ t ≤ n-1
kit > 1
E (kit) > 1
E (kit) << 1
kit* > 1
t=0
1 ≤ t ≤ n-1
t=n
1 ≤ t ≤ n-1
The margin of safety
The new taxonomy defines the Cartesian space of financial fluctuations
The behavior of units depends on their perception of risk → most units have
margins of safety that do not want to breach to avoid unnecessary risk
The main margin of safety is the solvency margin to avoid bankruptcy
The units struggle to stay sufficiently far from the insolvency line at kit = 1
The margin of safety may be expressed as a desired min distance from 1: 1- μ
→ I can represent the dynamic space of the financial conditions of each
financial unit in the following diagram
Fig.1: classification of financial units
2
kit
speculative
3
5
hyper-speculative
highly distressed
1
hedge
hyper-hedge
distressed
4
1
1-μi
6
1
kit*
Financial instability hypothesis: a model
We are now in a position to restate the core of the FIH with the aid of a simple model
interaction between the liquidity ratio and the solvency ratio (cash-flow approach),
(1)
kit
*

  i 
k
it  1  i  

kit
α>0
(2)
kit*
 i  kit  1
*
kit
β>0
This elementary Lotka-Volterra model is based on:
Vercelli, A., 2000, Financial Fragility and Cyclical Fluctuations, Structural Change and
Economic Dynamics. 1. pp.139-156);
Sordi, S., and A. Vercelli, 2006, Financial Fragility and Economic Fluctuations,
Journal of Economic Behaviour and Organization, 61 (4), pp. 543-561
Dieci, R, Sordi, S., and A.Vercelli, 2006, Financial fragility and global dynamics,
Chaos, Solitons and Fractals, 29(3), pp. 595-610
Definition of Minsky moment and Minsky process
This Lotka-Volterra model produces clockwise cycles that have
properties very similar to those described by Minsky in the FIH
kt
2
3
5
A
B
1
ω
A Minsky moment
A-B Minsky process
1
4
1-μ
6
1
k*t
The financial feedback and complex behavior
The feedback between k and k*, although apparently very simple, may
easily lead to complex behavior (regime shifts, bifurcations, chaos):
-present/future
Self-referential loop
{
-subject/object
-realized/expected
Dieci, R., Sordi, S., and A. Vercelli, 2006, Financial fragility and global
dynamics, Chaos, Solitons and Fractals, 29(3), pp.595-610
Sordi, S. and A. Vercelli, 2010, Heterogeneous expectations and strong
uncertainty in a Minskyian model of financial fluctuations, DEPFID
Discussion Paper n.7
Disequilibrium and instability
The model shows persistence of disequilibrium
dynamic instability emerges in consequence of the declining perception
of risk, the more so the more persistent is the boom
→ the safety margin 1- μ shifts towards the right, increasing the gap from
equilibrium → outwards spiral
when the awareness spreads that the margin of safety has been
overcome it may be too late: the inertia of the cycle pushes the economy
near the solvency barrier
→ growing financial fragility of financial units
financial fragility as the size of the minimum shock that pushes a
financial unity beyond the solvency barrier:
degree of structural instability that changes endogenously
→ dispersion → insolvency of a sizable subset of units→ contagion
Financial fluctuations: dynamic and structural instability
kt
P
1
ω ω’
1-μt
1-μt’
1
k*t
Sequence of financial cycles (→long cycle)
The degree of instability and fragility reached in the final stage of a
financial cycle depends on the characteristics of preceding cycles
gravity and length of the last crisis
Tends to grow in proportion to {
time distance from the last great crisis
The average safety margin tends to grow progressively:
germs of a successive great crisis:
In the last century long financial cycles of about 30 years:
trough-to-trough: 1930-1950, 1950-1982, 1982- 2010?
Long cycles in finance, USA, 1900-2008
the last one: 1980-2010?
US Stock market valuation
Source: Martin Wolf FT, 26.11.08 from Robert Shiller et al.
CAPE = Cyclically adjusted price-earning ratio
Q = cyclically adjusted Tobin Q
The neoliberal long cycle
We are at the end of a long cycle started at the turn of the 1970s
when the CAPE (cyclical adjusted price–earnings ratio) was at a
minimum
It continued to grow in the 1980s and 1990s culminating in 1999
then it was artificially kept above the long-period average
Greenspan put
through
{
monetary policy
Bernanke put
This policy strategy succeeded until 2007
The ongoing financial crisis:
insights from Minsky
Generally the evolution of facts makes theories obsolete
this is not the case of the FIH →
the evolution of facts made this approach progressively more important:
growing importance of finance:
-the ratio between financial and real assets (as measured by the FIR of
Goldsmith) grew from < 1 at the beginning of the 1980s to > 3 today
-GDP share of FIRE increased to 12%
-share of profits about 40% in 2007
non-financial firms
this is true also for {
households (↑shares, ↑pension funds)
theoretical
→↑ scope {
of the FIH
empirical
Policy implications
The approach outlined may guide us to draw
private sector
to get out of the crisis {
public sector
policy implications {
to avoid that “it” may happen again
Policy implications
Mainstream view on Minsky meltdown before the
crisis: impossible event
black swan: unpredictable event
(“once in a century”)
two viewpoints {
grey swan: recurrent event
(phase of a recurrent cycle)
The black swan view
Black swan view
black swan view: you cannot prevent it: “act of god” → only ex post therapy
-ex ante: max. returns: probability too low to be considered
in the usual ex ante rational calculations
Rationality {
-ex post: rationality of survival: different from max returns/min loss
In this view the main preventive measure: ↑ buffer stocks: liquid reserves
-however, only for shocks ≤ ε
to absorb exogenous unpredictable shocks {
-ignores intrinsic determinants:
periodic increase of financial fragility
Liquid reserves
This criticism may be clarified through the above model
↑Δ liquid reserves of financial units: shifts the solvency line to the right
typically a small percentage θ of unit’s net worth (no more than 10-20%):
A higher requirement may play a significant role when the lack of liquidity is
short-lived and not particularly serious; however:
-cannot be increased too much without jeopardizing the ROE of FIs
-rapidly depleted when the unit breaches the solvency line:
consistent liquid reserves can be burned out within a few days
-the desired margin of safety would shift with liquid reserves so that
financial fragility risk would remain unaffected
(sort of ‘Lucas critique’ applied to liquidity requirements)
Liquidity reserves constraint
kt
1+λ
1
ω ω’
1-μt’+ θ
1-μt
1-μt’
1
1+θ
k*t
The grey swan view
The grey swan view
Grey swan view: this approach shifts the attention towards systematic and
continuous prevention
→ cap to financial fragility such that shocks cannot trigger a meltdown
→ cyclical policy framework:
-Counter-cyclical policies (abandoned with Keynesianism in the early 1980s)
to be revived with the necessary cautions
liquidity constraints
-Ceiling to the financial cycle
{
leverage constraints
Liquidity constraint (flows)
liquidity constraint, i.e. a cap λ to the maximum value of the
imbalance between outflows and inflows
the financial deficit ratio Dit of the unit i at time t may be defined by
( 14 )
eit  yit
Dit  kit  1 
0
yit
The constraint kit ≤ 1 + λ (→ Dit ≤ λ ) translates in graphic terms in a
horizontal line above the liquidity line and sufficiently close to it
this constraint may be quite powerful: bounds the upward
fluctuations constraining the increase of financial fragility
→ it can greatly mitigate the Minsky processes avoiding Minsky
meltdowns
Leverage constraint
Let’s assume that the unit i trespasses the liquidity line at time τ
and that finances deficits by borrowing. The stock of debt Hit, of
the financial unit i at time t, for t > τ is thus given by
h
( 15 )
H it  H i   Dit dt
t > τ, h > τ.

the additional debt increases continuously in fields 2 and 3
→ a leverage cap would have effects similar to those of an
illiquidity cap
A compulsory requirement of liquid reserves is insufficient,
a compulsory cap on liquidity imbalances, and/or on the
admissible maximum leverage, look much more decisive:
capital requirements are less efficacious because buffer stocks
are typically used too late when they are easily depleted
Liquidity reserves constraint
and leverage constraint
kt
2
3
1+λ
1
ω ω’
1
4
1-μt
1-μt’
1
k*t
Structural interventions (1)
We have to regulate finance in such a way to reduce its weight in the
economy (Rogoff: about the same size of the ‘1970s)
-Dimensional cap to private FI: the leading FI are “too big to fail” and “too
big to be bailed out”; when bail-out possible: “privatization of profits and
nationalization of losses”
Greenspan: graduated capital requirement → useful but insufficient
-Cap to deficit and/or leverage to stabilize financial fluctuations
(Geanakoplos, 2010; Adrian & Shin 2009)
-Tax on financial transactions: proceedings to support employment and
the real economy along the lines of sustainable development
(T.Matheson, IMF, 2010), already adopted by 23 countries.
-Segmentation: updating of the Glass-Steagall act (1933) to stop
contagion and to avoid conflicts of interests (Kregel, Orléan…)
-Separation between revision of balance sheets and consultancy
Structural interventions (2)
To reach the goal we need a much improved regulation…
regulation philosophy for existing regulating institutions
-New {
International institutions to regulate financial markets
to be authorized as medical drugs
-Financial innovations {
performance bond
… and sheer repression:
-Prohibition of shadow finance
{
-offshore financial centers
-OTC derivatives
-off-balance sheet operations
Structural interventions (3)
I am aware that these recipes may look utopian
However a process of de-financialization already happened in history as a
reaction to the Great Depression: and this initiated a period of growth and
financial stability
Main objection: negative impact on growth
This is true only within the current model of growth in which financial
investment (often mere speculation) crowds out productive investment
In a sustainable model of growth the reduction of expected financial profits
would shift investment away from the financial sector and back towards the
real sector
In any case the austerity measures are now not the solution
(Pollin, 2010) but an aggravating factor
Is there a way out?
In the absence of drastic measures of this kind we may experience
soon other major waves before the Great Recession comes to
an end
or we may precipitate soon in a new Great Crisis
I think that we have to find the courage of implementing the
drastic reforms mentioned above before it is too late:
before the “big one” happens…