Financial Instability Hypothesis Archives

Minsky is more than a moment

After the Great Financial Crisis, Minsky rose to fame. But few people grasp the breadth and depth of his work beyond the “Minsky Moment”. If that’s you, Daniel Neilson’s recent book is a worthy read. By Ayoze Alfageme.

A decade after the Great Financial Crisis, Minsky presents a meticulous reconstruction of Hyman Minsky‘s lifework that goes well beyond the mere explanation of financial bubble bursts. Indeed, Neilson devotes only a few pages to what Minsky is best known for—his Financial Instability Hypothesis. The reason is not for its lack of relevance within Minsky’s theory, but because the author places it as one piece of an overall financial theory of capitalism that he painstakingly elaborates in a mere 150 pages. Presenting Minsky’s ideas in a comprehensive and exhaustive way is not an easy task, given that he worked out his thinking by sketching his theory piecemeal in various places as he witnessed history pass by. Thus, the author elaborates three different threads through which he deconstructs Minsky’s work into elements to be then reconstructed and presented as a thorough vision of capitalism.

A financial theory of capitalism

The first thread comprises four out of eight chapters of the book and deals with Minsky’s financial theory. In modern societies, a matrix of balance sheets connects all agents via debt and credit commitments—assets and liabilities—that have arisen from past payment decisions. Minsky shows that payment structure, intrinsic to capitalist societies, is prone to recurrent crises due to the imperative requirement to repay debts. This requirement, or ‘survival constraint’ as Minsky termed it, forces everyone to generate greater monetary inflows than outflows. When debts come due, debtors search for a liquid position that allows them to redeem their debts using money or, as Minsky said, whatever the lender will accept to write off the debt. Position making is the action through which assets and/or liabilities are sold if a unit is illiquid and in need of cash. The famous hedge, speculative, and Ponzi positions are nothing more than a form of position making—a search for liquidity. A crisis might be triggered by the effect upon other units of a unit’s inability to pay i.e. to find liquidity. A widespread financial crisis unfolds when the market for position making for liquidity comes to a halt. At this point, the role of the central bank is to step in as a lender of last resort—the market maker of last resort—that can blow liquidity into the system as its only initiative.

The making of a maverick economist

The second thread, interwoven with the first, narrates Minsky’s path to becoming the economist he was. For example, we learn from Henry Simons, his professor in Chicago, how Minsky adopted a practical outlook view of Simon’s view on the requirement to pay debts and how he added the theoretical and institutional issues of liquidity to Schumpeter and Keynes’ monetary theory of production. In Neilson’s account, liquidity is at the core of Minsky’s financial theory. Minsky’s considerations about liquidity, uncertainty, and time, stand as the main divergences between his approach and that of the mainstream.

The third and final thread of the book deals with the position Minsky took towards the rest of the economist profession, disentangling the contradictions between the two. In need of a new language through which he could express the knowledge he wanted to convey, Minsky found himself at the margins of the profession and in conscious opposition to the mainstream. Interestingly, the book also reveals how even interpretations by those who, as post-Keynesians of different strands claiming to Minsky’s insights, sometimes fail to understand his core contributions.

Throughout the book, Neilson successfully presents Minsky’s theory and policy and the intellectual challenges he faced during his career as an economist. The book also encompasses his Ph.D. thesis, the writing of his two books—John Maynard Keynes and Stabilizing an Unstable Economy—his collaborations with the financial sector, his financial analyses for the public sector, as well as the economic and financial crises he witnessed and eagerly strove to analyze. Overall, the author conveys, with a dash of critical insights of his own, what he and his professor, Perry Mehrling, consider to be the most important thing we can learn from Minsky: his vision of how financial capitalism works

Buy the book: Minsky. By Daniel H. Neilson. Polity Press: Cambridge, 2019. 224 pages, £16.99.

About the Author: Ayoze is teaching assistant and PhD candidate at the University of Geneva. Twitter: @_Ayoze_

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This article was originally posted in Economic Issues, Vol. 25, Part 1, 2020.
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The financial crisis was a Minsky moment but we live in Strange times

This is the story of Susan Strange and Hyman Minsky, two renegade economists who spent a lifetime warning of a global financial crisis. When it hit in 2008, a decade after their deaths, only one rocketed to stardom.

By Nat Dyer.

When Lehman Brothers went belly up and the world’s financial markets froze in the great crash of 2008, the profession of economics was thrown into crisis along with the economy. Mainstream, neo-classical economists had largely left finance and debt out of their models. They had assumed that Western financial systems were too sophisticated to fail. It was a catastrophic mistake. The rare economists who had studied financial instability suddenly became gurus. None more so than Hyman Minsky.

Minsky died in 1996 a relatively obscure post-Keynesian academic. He was only mentioned once by The Economist in his lifetime. After 2008, his writings were pored over by economists and included in the standard economics textbooks. Although not a household name, Minsky is today an economic rockstar named checked by the Chair of the Federal Reserve and Governors of the Bank of England. One economist summed it up when he said, “We’re all Minskites now”. The global financial crisis itself is often called a “Minsky moment”. But not all radical economic thinkers were lifted by the same tide.

Susan Strange was more well-known than Minsky in her lifetime (see Google ngram graph below). One of the founders of the field of international political economy, she taught for decades at the London School of Economics. Alongside her academic work, she raised six children and wrote books for the general public warning of the growing systemic risks in financial markets. When she died in 1998 The Times, The Guardian and The Independent all published an obituary for this “world-leading thinker”.

The two renegade economic thinkers, although working in different disciplines, had much in common. They both gleefully swam against the tide their entire careers by studying financial instability. They were both outspoken outsiders who preferred to teach economics with words rather than equations and were skeptical of the elegant economic models of the day. They were big thinkers haunted by the shadow of the 1930s Great Depression. They both died a decade before being vindicated by the 2008 financial crisis. And, they read each other’s work.

The New York Times called Susan Strange’s 1986 Casino Capitalism “a polemic in the best sense of the word.” Calling attention to financial innovation and the boom in derivatives, the book argued that, “The Western financial system is rapidly coming to resemble nothing as much as a vast casino.” Minsky, in his review, said that the title was an “apt label” for Western economies. Strange provided a much-needed antidote, he said, to economists “comfortable wearing the blinders of neoclassical theory” by showing that markets cannot work without political authority. He probably liked the part where Strange praised his ideas too.

Casino Capitalism hailed Minsky’s ‘Financial Instability Hypothesis’ way before it was fashionable. Strange singled out Minsky as one of a “rare few who have spent a lifetime trying to teach students about the working of the financial and banking system” and whose ideas might allow us to anticipate and moderate a future financial crisis. Minsky’s concept of ‘money manager capitalism’ has been compared to ‘casino capitalism’.

But, put Susan Strange’s name into Google News today or ask participants at meetings on economics about her and you don’t get much back. They will sometimes recognise her name but not much more. Outside a small group, she’s a historical footnote, better remembered for helping to create a new field than the force or originality of her ideas. It is as if two people tipped the police off about a criminal on the run but only one of them got the reward money.

So, why did Strange’s reputation sink after the global financial crisis when Minsky’s soared?

Professor Anastasia Nesvetailova of City, University of London, one of the few academics who has studied both thinkers, believes it is due, in part, to their academic departments. “Minsky may have been a critical economist but he was still an economist,” she told me. Strange studied economics, but then worked as a financial journalist before helping to create the field of international political economy, now considered – against Strange’s wishes – a sub-discipline of international relations. Economics is simply a more prestigious field in politics, the media and on university campuses, Nesvetailova said, and Minsky benefited from that. “Unfortunately, [Strange] remains that kind of dot in between different places.”

As we live through a political backlash to the 2008 crisis and the IMF warns another one might be on the way, Strange’s broader global political perspective is a bonus. In States and Markets, she sets outs a model for global structural power which brings in finance, production, security and knowledge. Her writings predicted the network of international currency swaps set up by the Federal Reserve after the global financial crisis, according to the only book written about Strange since 2008. Her work foreshadowed the global financial crime wave. And, she argued repeatedly that volatile financial markets and a growing gap between rich and poor would lead to volatile politics and resurgent nationalism, which is embarrassingly relevant today. The financial crisis may have been a ‘Minsky moment’ but we live in Strange times.

This global political economic view explains why Strange criticised Minsky and other post-Keynesians for thinking in “single economy terms”. Most of their models look at the workings of one economy, usually the United States, not how economies are woven together across the world. This allows Strange to consider “contagion”: how financial crises can flow across borders. It’s a more real-world vision of what happens with global finance and national regulation. Her greatest strength, however, also reduced her appeal in some quarters as it means Strange’s work is less easy to model and express in mathematics.

Minsky found fault in Strange too. She should have more squarely based her analysis on Keynes, he said and showed the trade-off between speculation and investment. Tellingly, his critique is at its weakest when engaging with global politics. Strange unfairly blamed the United States for the global financial mess, Minsky wrote, even though it was no longer the premier world power. Minsky was only repeating the conventional view when he wrote that in 1987 but it was bad timing: two years later the Berlin Wall fell ushering in unprecedented US dominance.

In her last, unfinished paper in 1998 Strange was still banging the drum for Minsky’s “nearly-forgotten elaboration of [John Maynard] Keynes’ analysis”. Now it’s her rich and insightful work that is nearly forgotten outside international relations courses. A jewel trodden into the mud. Just as Minsky is read to understand how “economic stability breeds instability”, let’s also read Strange to appreciate her core message that while financial markets are good servants, they are bad masters.

About the author

Nat Dyer is a freelance writer based in London. He has an MSc in International and European Politics from Edinburgh University. He was previously a campaigner with Global Witness, an anti-corruption group. He tweets at @natjdyer.

Google Ngram showing the frequency of references to Susan Strange (red) and Hyman Minsky (blue) from 1940 to 2008

Strange was more referenced in her lifetime than Hyman Minsky. Google Ngram’s search only goes up to 2008. After 2008, we would likely see a hockey stick spike for Minsky and Strange continuing to fall.

Using Minsky to Better Understand Economic Development – Part 2

The work of Hyman Minsky highlighted the essential role of finance in the capital development of an economy. The greater a nation’s reliance on debt relative to internal funds, the more “fragile” the economy becomes. The first part of this post used these insights to uncover the weaknesses of today’s global economy. This part will discuss an alternative international structure that could address these issues.

Minsky defines our current economic system as “money manager capitalism,” a structure composed of huge pools of highly leveraged private debt. He explains that this system originated in the US following the end of Bretton Woods, and has since been expanded with the help of financial innovations and a series of economic and institutional reforms. Observing how this system gave rise to fragile economies, Minsky looked to the work of John Maynard Keynes as a start point for an alternative.

In the original discussions of the post-war Bretton Woods, Keynes proposed the creation of a stable financial system in which credits and debits between countries would clear off through an international clearing union (see Keynes’s collected writings, 1980).

This idea can be put in reasonably simple terms: countries would hold accounts in an International Clearing Union (ICU) that works like a “bank.” These accounts are denominated in a notional unit of account to which nation’s own currencies have a previously agreed to an exchange rate. The notional unit of account – Keynes called it the bancor – then serves to clear the trade imbalances between member countries. Nations would have a yearly adjusted quota of credits and debts that could be accumulated based on previous results of their trade balance. If this quota is surpassed, an “incentive” – e.g. taxes or interest charges – is applied. If the imbalances are more than a defined amount of the quota, further adjustments might be required, such as exchange, fiscal, and monetary policies.

The most interesting feature of this plan is the symmetric adjustment to both debtors and creditors. Instead of having the burden being placed only on the weakest party, surplus countries would also have to adapt their economies to meet the balance requirement. That means they would have to increase the monetary and fiscal stimulus to their domestic economies in order to raise the demand for foreign goods. Unlike a pro-cyclical contractionist policy forced onto debtor countries, the ICU system would act counter-cyclically by stimulating demand.

Because the bancor cannot be exchanged or accumulated, it would operate without a freely convertible international standard (which today is the dollar). This way, the system’s deflationary bias would be mitigated. Developing countries would no longer accumulate foreign reserves to counter potential balance-of-payment crises. Capital flows would also be controlled since no speculation or flow to finance excessive deficits would be required. Current accounts would be balanced by increasing trade rather than capital flows. Moreover, the ICU would be able to act as an international lender of last resort, providing liquidity in times of stress by crediting countries’ accounts.

Such a system would support international trade and domestic demand, countercyclical policies, and financial stability. It would pave the way not only for development in emerging economies (who would completely free their domestic policies from the boom-bust cycle of capital flows) but also for job creation in the developed world. Instead of curbing fiscal expansion and foreign trade, it would stimulate them – as it is much needed to take the world economy off the current low growth trap.

It should be noted that a balanced current account is not well suited for two common development strategies. The first is import substitution industrialization, which involves running a current account deficit. The second is export-led development, which involves a current account surplus. However, the ICU removes much of the need for such approaches to development. Since all payments would be expressed in the nation’s own currency, every country, regardless it’s size or economic power, would have the necessary policy space to fully mobilize its domestic resources while sustaining its hedge profile and monetary sovereignty.

Minsky showed that capable international institutions are crucial to creating the conditions for capital development. Thus far, our international institutions have failed in this respect, and we are due for a reform.

Undeniably, some measures towards a structural change have already been taken in the past decade. The IMF, for example, now has less power over emerging economies than before. But this is not sufficient, and it is up to the emerging economies to push for more. Unfortunately, the ICU system requires an international cooperation of a level that will be hard to accomplish. Aiming for a second-best solution is tempting. But let’s keep in mind that Brexit and Trump were improbable too. So why not consider that the next unlikely thing could be a positive one?

Using Minsky to Better Understand Economic Development – Part 1

The global system has seen two major shocks in 2016: the Brexit vote and Trump. What these events have in common is their populist rhetoric that promised to bring back jobs. These elections have tapped into growing anxiety over job security, which has not been addressed by most governments and has given room for demagogues to tap into the anger of the people. They reflect a problem that transcends the boundaries of any single nation: the global economy has been in a slump for almost a decade. Governments need to create jobs, and public fiscal stimulus is the way to do so. To allow it, we must rethink that system.

To understand why we have to consider the international system in which nation states currently operate in. Its current characteristics present challenges for developed and developing economies alike. There are two important features to consider: first, the system creates a deflationary bias by requiring recessionary adjustments and hoarding of the international mean of payment (i.e. dollars). Second, it lacks mechanisms to offset the chronic surpluses and deficits between nations, thus breeding financial instability. In a nutshell, it leads to poor creation and distribution of demand that is managed through capital flows. Instead of propping up demand, the global economic system props up debt.

This post will be split into two parts. This first part will employ the theories of Hyman Minsky to explain the features of our current global economy. Next week, we will follow up to discuss an alternative system that would allow for a better distribution of demand among countries and would support emerging economies’ development by freeing them from the swings of international markets.

In his Financial Instability Hypothesis, Minsky addresses the ability of a company to honor its debt commitments. Companies can finance investment through previously retained earnings (internal funds) and/or by borrowing (external funds). If retained earnings prove to be insufficient, and the company comes more and more reliant on borrowed funds, the company’s balance sheet structure shifts from being stable to unstable. As presented in a previous post on this blog, Minsky described this process as moving from a stable “hedge” profile to a riskier “speculative” profile, and finally to a dangerous “Ponzi” profile.

Similarly, a country has three ways in which it can meet its debt commitments denominated in foreign currency: i) by obtaining foreign exchange through current account surpluses; ii) by using the stock of international reserves (obtained through previous current account surpluses); and iii) by obtaining access to foreign savings, i.e. borrowing. The first characterizes a hedge financial profile in which the cash inflows are sufficient to pay the foreign currency denominated liabilities. Any mismatch between inflows and outflows can be covered by reserves (its cushion of safety) or by borrowing; while the former can still characterize a hedge profile – as long as the cushion of safety is big enough to cover the shortfall for the necessary period of time – the latter is said to be speculative. In other words, the country borrows to cover a mismatch with the expectation that future revenues will be used to meet those debt obligations.

A situation in which further rounds of borrowing are necessary to meet those commitments is by definition a Ponzi scheme. It can only be sustained over time if it manages to keep fooling investors to continue to lend. Once a greater fool is not found and financial flows are reversed, the economy collapses in a Fisher-type debt deflation: as assets are liquidated to meet those financial obligations, their prices fall and the debt burden becomes increasingly heavier. The case of a country is different from a company, where outflows are often accurately expected, and it commonly leads to massive capital flight, currency devaluation, fall in public bond prices and increase in its premiums (i.e. interest rate payments). This last point illustrates the implications of accumulating foreign liabilities – reserves included – and implies the growth of negative net financial flows from borrowers to creditors through debt servicing. In general, from developing to developed countries.

The adjustment process punishes the borrower much harder than the lender. Greece presents a clear example. For the borrowing country, the standard imposed remedy is austerity: curtail of imports and public expenditure in order to forcefully meet those debts. Or, more often, to stir up enough confidence and access additional financial resources from private investors; in other words, continuing the Ponzi financing. Even in a case where interest payments on the borrowed funds are lower than the rate of capital inflow, the stock of debt would still expand, increasing financial fragility. A development strategy dependable on increasing usage of foreign savings is thus not feasible.

Of course, economic development is an extremely broad subject and we sure don’t want to commit the mistake of suggesting a “one-size-fits-it-all” policy a la neoliberal disciples. Nonetheless, a common issue for many developing economies is the lack of complexity and variety of its production structure – heavily dependent on primary goods – and the low price-elasticity of demand for its exports, which means that shifts in prices (exchange rate) do not do much to stimulate exports (increasing demand). As such, price adjustments might not always work as expected. This is one of the rationales behind the familiar “import substitution industrialization” strategy that tragically seems to have become the case for the UK and US.

These common characteristics affect the ability of emerging economies to face both up- and downswings of the international economy with countercyclical policies. While international liquidity is abundant in booming periods, it becomes extremely scarce during the slumps. Both capital floods and flights can be domestically disruptive for a developing economy, affecting its employment and output level, solvency, and – ultimately, its sovereign power. With scarce demand and international liquidity, the indebted economy falls into the debt-deflation spiral: it has to incur in a recession big enough to collapse imports at a faster rate than exports thus generating surpluses to clear off debt.

It should be clear that besides being completely inefficient – as opposed to the argument commonly used by “free-the-capital” defenders – the current economic system does little to stimulate demand. It is quite the contrary. Notwithstanding, after almost 10 years after the financial crisis, the world economy is still suffering the consequences of economic “freedom,” and the fighting tool has focused excessively on monetary rather than fiscal policy. Instead of cooperation, we are prone to have currency wars, protectionism, “beggar-thy-neighbor” policies and chronic debt accumulation.

These points of criticism are not novel, but they do deserve more of our attention. The same applies to their solutions, which are the focus of Part 2 of this article.

Carbon Trading, Sustainable Development and Financial Fragility

The response to climate change is one of the most pressing policy issues of our time. Carbon trading assets are currently worth more than $100 billion. This market is expected to reach $3 trillion by 2020. In Stabilizing an Unstable Economy Hyman Minsky notes that the markets for financial assets are inherently unstable, leading to the cyclical behavior of the economic system. How effective then are market-based solutions to solving climate change? It might just be that carbon markets have not reduced environmental instability and may increase financial instability of the entire economic system.

The core of carbon trading isnot trading of physical GHGs, but the trading of the right to emit GHGs and the unit of account is a ton of carbon dioxide equivalent (tCO₂e). The carbon market stems from the Kyoto Protocol, and its specifics are target of discussion as scholars debate about the legal characteristics of the carbon unit. Some countries view it as a commodity while others see it as a monetary currency.

Under the Kyoto Protocol trading mechanisms were made up of three types: international emissions trading, the Clean Development Mechanism (CDM), and Joint Implementation (JI). The European Union Emission Trading System (EU ETS) is the world’s largest carbon market. According to the 2016 ICAP worldwide emissions report, there are 17 emissions trading systems operating around the world, which are currently pricing more than four billion tons of GHG emissions. In 2017, two new systems will be launched: China and Ontario, the former will become the largest of such systems, and will drive worldwide coverage of ETSs to reach seven billion tons of emissions by 2017.

Voluntary markets exchanges (carbon markets outside the Kyoto) are also on the rise because they make trading, hedging and risk management easier by providing liquidity. Furthermore, they develop sophisticated financial instruments such as CER futures, options, and swaps, which will help establish a price forecast for carbon. Some of these markets are the Chicago Climate Exchange (CCX), Multi-Commodity Exchange of India (MCX), and Asian Carbon Trade Exchange.

Sustainable Development

From their foundation, carbon markets have failed to address the underlying root causes of climate change. They divert money from technological investment that will actually reduce the use of fossil fuels towards the financial markets. Furthermore, they are causing instability in the environment through the use of carbon offsets, which have caused massive green grabs to occur in the global South, and through outsourcing emissions to developing nations. Carbon offsets were created by Kyoto to describe emissions reductions projects that are not covered by an ETS. For instance, tree plantations, fuel switches, wind farms, hydroelectric dams…etc.

The world’s richest have over-consumed the planet to the brink of ecological disaster. Instead of reducing emissions within their own countries, they have created a carbon dump in poorer regions. As such, emissions trading system represent the world’s greatest privatization of a natural asset. The Kyoto protocol is set up in a way that carbon sink projects (forests, oceans, etc.) are only accepted when people with official status manage them. Hence, it expands the potential for neocolonial land-grabbing to occur. Rainforest inhabited by indigenous people will only qualify as “managed” under the Kyoto when they are run by the state or a registered private company.

Furthermore, carbon trading has also failed to reduce global GHGs emissions. When a country claims to have reduced its carbon emissions, one must question whether it is by adopting low-carbon technologies, like how Sweden used well-crafted public policies and market incentives to decarbonization, or by outsourcing its emissions to another country, most likely to developing nations. For example, the Chinese government has questioned whether the emissions coming out of Chinese smokestacks were really ‘Chinese’ or should they be accounted to those in Western countries who are consuming Chinese goods or are owned by joint venues with developed countries. The question arose because Europe claimed that it was making progress on climate change based on tabulating the physical locations of molecules. Larry Lohmann phrased it perfectly when he said that Europe’s statistical claim “[conceal[s] an important fact that it has offshored much of its emissions [to China].” Take the UK, it has not in fact reduced its emissions it merely offshored one-third of its emissions by not accounting for emissions of imported goods and international travel.

Carbon markets have had many fraudulent activities within them. In 2002, the UK had a trial emissions trading scheme worth £215 million, which resulted in fraud. Three chemical corporations had been given £93 million in incentives when they had already met their reduction target. Another famous fraudulent activity revolved around international offset projects whereby companies would create GHGs just to destroy them and make money off of the credits.

As nature is being commodified and privatized,the current policies for sustainable development, under the guise of conservation, are alienating the poor from their means of livelihood by securing resources for organizations. These indigenous people — land users — are seen as needing to be saved from their primitive ways and to be educated on utilizing sustainable development within the bounds of the market. If it sounds like colonialism that is because it is.

For example, there exists specific types of green grabs known as conservation enclosures where the market is seen as the best way to conserve biodiversity. Hence, authorities are privatizing, commercializing and commoditizing nature at an alarming rate through payment for ecosystem services to wildlife derivatives. The Convention on Biological Diversity (CBD), a multilateral treaty set up at the 1992 UN Earth Summit has a target the protection of 17 percent of terrestrial and inland water and 10 percent of coastal and marine areas. For instance, Conservation International (CI) pushed the government of Madagascar to protect 10 percent of its territory, while in Mozambique a British company negotiated a lease with the government for 19 percent of the country’s land. President Elizabeth Sirleaf Johnson of Liberia called for the extradition of a British businessman accused of bribery over a $2.2 billion carbon offsetting deal. The deal was to lease one-fifth of Liberia’s forests, which account for 32 percent of its land. In Uganda, a Norwegian company leased land for a carbon sink project, which evicted 8,000 people in 13 villages.

In Oxfam Australia’s 2016 report on land grabs, palm oil has become “responsible for large-scale deforestation, extensive carbon emissions and the critical endangerment of species… India, China and the European Union (EU) are the largest consumers of palm oil globally.” The European Union’s renewable energy policy being a significant driver of global palm oil demand due to its aim to source 10 percent of transport energy from renewable sources by 2020, which has increased its palm oil usage by 365 percent.

Reducing Emissions from Deforestation and Forest Degradation (REDD+) is an effort to create a financial value for the carbon that is stored in forests. It is used to justify green grabbing and is expected to be one of the biggest land grabs in history. By using REDD+ as a conservation mechanism and a financial stream, “the CDB is both legitimating the commodity of carbon itself and helping to create the market for its trade.” The CDB is forming new nature markets along with new nature derivatives whereby investors speculate on future values encompassed in, for instance, species extinction like that of tigers.

Financial Fragility

Hyman Minsky was fully aware that a capitalist system was a monetary system with financial institutions that were prone to instability. Minsky is famous for saying that the strength of capitalism is that it comes in at least 57 varieties. The last and current stage is Money Manager Capitalism, which was made up off highly levered profit- seeking organizations like that of money market mutual funds, mutual funds, sovereign wealth funds, and private pension funds. The financial instability hypothesis argues that the internal dynamics of capitalist economies over time give rise to financial structures, which are prone to debt deflations, the collapse of asset values, and deep depressions. Minsky has always warned, “Stability is Destabilizing.”

Money managers act as agents. They pursue short-term profits by trading instruments that are not easily verifiable, which makes fraud likely possible in carbon markets. The dramatic rise in securitization has opened up national boundaries leading to the internationalization of finance. Securitization within the carbon markets increases the risk of leading to boom-bust cycles. At present, speculators are the major players in carbon trading and their dominance in carbon markets is growing at an alarming rate. Financialization is an important precondition for the rise and operation of carbon offsets. The financial innovation in this scheme is that it uses nature itself as a financial instrument. Moreover, it is selling nature to save it and then saving nature to trade it.

‘Green bonds’ are carbon assets that are sold to the Northern hemisphere, backed by Southern land and Southern public funds. Lohmann shares that financial speculation of collateralized debt obligations (CDOs) are at least based on specifiable mortgages on actual houses while climate commodity or subprime carbon cannot be specified, quantified, or verified even in principle. Even conservatives and Republicans have said, “if you like credit default swaps, you’re going to love carbon derivatives.” It has become apparent that carbon markets are not only driven by trade, but also by speculation. Carbon derivatives are growing at a fast rate as speculators are moving from other assets towards carbon. Whereas once investors bet on the collapse of the US housing market, there are some traders who are betting on the collapse of the carbon credit market.

As more investors, specifically hedge funds, enter the carbon markets, they increase market volatility and create an asset bubble or ‘carbon bubble’. Money managers by acting as agents trade carbons and increase financial fragility. Their income is driven by assets under management and short-term rates of return. Hence if they miss the benchmark, they will lose their clients. So they act on short profit bases by taking risky positions, and carbon trading provides those risks. In brief, using Minsky’s theory, we can predict with confidence that the carbon market is inherently unstable and that in addition to its not achieving its goal of reducing emissions, it is also heading to a financial disaster.

Even though Minsky pushed for regulation when it came to financial markets, regulating carbon markets will not solve the problem. Tighter regulation of carbon markets, particularly secondary and derivative markets is just a Band-Aid solution and will fail to affect fundamental change. Financial markets have had to be bailed out again and again. However, as a British Climate Camp activist said “nature doesn’t do bailouts.” On a global scale, GHG emissions have gone up. There is an offshoring of emissions. The best policy would be eliminating offsets, specifically from the developing world. Furthermore, there needs to be policies that encourage low-carbon technology as used in Sweden. Another policy recommendations would be a harmonized carbon tax.

Written by Mariamawit F. Tadesse
Illustrations by Heske van Doornen

Stability is Destabilizing

In a recent interview with Andrew Ross Sorkin, published in The New York Times, President Obama argued that the U.S. economy is in fine shape, despite public feelings that it might not be. Then a few days later the same newspaper ran an interview with William C. Dudley, the president of the Federal Reserve Bank of New York, in which he foresaw continued economic growth. And like the president of the Richmond Fed, Mr. Dudley made the case for slowly raising interest rates because the economy is “on track” and global conditions are “dramatically better.”

The rhetoric coming from these top policymakers can seem rather soothing to most people, including many economists. However, we know that Hyman Minsky would have remained highly skeptical. In fact, Minsky famously argued that “stability is destabilizing,” and that is because periods of economic instability and recessionary episodes emerge naturally out of the normal functioning of a prosperous modern capitalist economy.

For Minsky the nature of instability is linked to the relation between finance and investment in capital assets during the business cycle. Economic agents often compromise future incomes in order to secure the assets they need to undertake production. The accumulation of capital in the economy is largely financed by borrowing, which is recorded as liabilities on balance sheets. The liabilities represent a group of payment commitments on a future date, while the assets held represent a series of expected cash receipts from operations. The performance of the economy will later either validate or invalidate the structure of those balance sheets. Even though Minsky was talking about the capital development of the economy, his argument can be broadly extended to any economic unit; from a corporation borrowing to build its new headquarters to a person borrowing to buy a car or pay for college.

In his Financial Instability Hypothesis (FIH), Minsky identified the degree of financial fragility in the system by defining three income-debt relations for economic units: hedge, speculative, and Ponzi finance. For hedge financing units, the income flows from operations are enough to fulfill debt commitments outflows in every period. For units involved in speculative finance, the income flows are only enough to meet the interest component of their obligations and they will have to roll over debt because they cannot repay the principal. For Ponzi finance, the income flows from operations are not enough to cover the interest costs of their loans or the repayment of principal. Ponzi units highly depend on the possibility of refinancing their debt, otherwise they have to resort to the liquidation of assets or issuing new liabilities in order to meet their obligations.

The movement to more units engaged in Ponzi finance happens as a natural consequence of periods of stability and prosperity. During economic expansions, borrowers and lenders become confident in the ability of the former to meet cash commitments, which is a rational response based on recent past experiences and on the higher probabilities of success associated with the expansionary environment.

Thus, economic units are not likely to have difficulties to meet their payment commitments as they come due during economic expansions. However, such optimistic expectations lead to relaxing lending standards and reducing margins of safety. They also validate riskier projects, the use of more debt relative to assets, and lower liquidity; all of which increase the fragility of the economic system (for more see here and here).

Borrowers and lenders seem to operate on a hit-or-miss basis; if a behavior is successful, it will be rewarded and it will be repeated. So the behaviors described above will continue, and in fact be encouraged, until the turn of the economic cycle. Thus, while the economy prospers, financial positions are becoming increasingly fragile under the stable surface. Indeed, according to Minsky, during prolonged periods of prosperity the modern capitalist economy tends to move from a robust financial structure dominated by hedge financing units, to what he called a “deviation amplifying system” dominated by abundant speculative and Ponzi financing units.

The boom gives way to the bust when interest rates suddenly rise or when realized income flows fail to meet what was projected (note that economic units need not incur losses, but just have revenues depart from expectations – so basically any small shock to a fragile economy can potentially trigger a crisis). When the economic environment changes, income flows begin to fall and Ponzi units find it impossible to borrow to sustain their positions. They will then try to make position by selling out position; this means selling assets to meet their payments. The consequence of a generalized sell-off is to put downward pressure on asset prices, which can make the market prices too low as to generate sufficient income to meet the commitments – making this operation self-defeating. These dynamics, plus the excess supply, reinforce the necessity to sell and raise the real debt burden, leading to a potential Fisher-style debt deflation. These processes reset the system, starting again from a robust financial position – because all the fragile positions were washed off by the debt deflation – but will eventually give way to another crisis.

The idea that “stability is destabilizing” is summarized by Minsky’s two theorems of financial fragility in the FIH: (I) the economy has financing regimes under which it is stable (hedge) and financing regimes in which it is unstable (speculative and Ponzi); and (II) over periods of prolonged prosperity, the economy transitions from financial relations that make for a stable system to financial relations that make for an unstable system. In other words, the economy tends to move from a financial structure with abundant units engaged in hedge finance to a structure dominated by speculative and Ponzi units. The natural shift from hedge positions to speculative to Ponzi is a required condition for instability to arise, and, as explained above, the move (and the erosion of margins of safety) happens during periods of economic stability and prosperity. One of Minsky’s most important contributions was to point out that the process leading to an unstable system is an inevitable, endogenous, and evolutionary process of the modern capitalist economy.

So, what can we learn from all of this? Well, the next time you hear politicians or big shot economists talking about how stable the economy is and how on track it is, remember Minsky and remain skeptical.

Written by Oscar Valdes-Viera