Financial Instability (“Minsky”) Regimes
“Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.”
- Hyman Minsky
The Financial Instability Hypothesis (FIH)
The Financial Instability Hypothesis was formulated by Hyman Minsky. Minsky wrote many times about his hypothesis, but perhaps the most concise version is in “The Financial Instability Hypothesis: A Restatement” (1978). According to Minsky, the financial system carries the seeds of its own destruction through increasing leverage. Leverage increases because in a long period of growth, banks and other lenders become complacent, reduce lending standards, and allow significant leverage through borrowing. Central banks support this environment through a prolonged time of low interest rates. Eventually markets and the economy become so levered that a small selloff in asset values can cause a panic. Why? The loans are backed by assets. As the assets lose value the holders of the loan require more collateral causing further selling and a downward spiral.
Minsky was largely ridiculed for the FIH because he had little empirical evidence to back up his claims. But a number of researchers began looking into it including future Fed Chair, Ben Bernanke, and published research in the 1970s and 1980s that largely supported the FIH. Most of that research was little noticed. But the Russian Financial Crisis of 1998 unfolded as the FIH said it would. Economist Paul Allen McCulley at that time coined the phrase “Minsky Moment” to describe the financial crisis. The term came up again in the Global Financial Crisis (GFC) of 2008 which cemented the FIH into the mainstream of economics and made “Minsky Moment” a catch phrase in market circles.
The Financial Instability Hypothesis describes three phases of increasing leverage which end in a cataclysmic fourth phase:
(1) Hedge Finance: Assets are equal to or greater than liabilities.
(2) Speculative Finance: Liabilities are greater than assets through leverage, but not “excessive.”
(3) Ponzi Finance: Leverage is so high that earnings can only occur through capital gains .
(4) The “Minsky Moment:” A fall in asset prices causes mass deleveraging as lenders call for more capital to back up loans. The financial system becomes unstable.
Academic research has shown that the financial instability cycle lasts from 8 to 20 years and is longer than the business or market cycle, which is 4 to 6 years. But when these cycles coincide, the resulting recessions tend to be longer and deeper than recessions caused by issues in the real economy or a stock market decline. The GFC, again, was a textbook example of this phenomena. So it would be useful to know when an approaching recession is tied to the financial system as opposed to the business or stock market cycle.
The Financial Instability Regime Indicator (FIRI) and the MUSI
The FIRI uses measures of leverage in the non-financial parts the economy, basically consumers and non-bank institutions, to determine the state of leverage in the financial system and whether it is higher or lower than historical norms. The information from FIRI is mostly useful when combined with the Market Uncertainty State Indicator (MUSI) since a “Minsky Moment” occurs when leverage is high and asset prices fall resulting in mass deleveraging.
Combining these two measures together creates four states:
1) Normal liquidity: leverage is low and market uncertainty is low
2) Normal leverage: leverage is high and market uncertainty is low
3) Excessive leverage: leverage is high and market uncertainty is high
4) Excessive liquidity: leverage is low and market uncertainty is high
The conditional, integrated indicators separate Minsky’s “speculative” finance from "Ponzi” finance states. Leverage isn’t bad if markets are resilient. In fact leverage can be quite beneficial. “Normal leverage” equates to many economic expansions and bull markets. But high leverage accompanied by asset declines leads to mass deleveraging. That’s why the “fragile” MUSI state combines high uncertainty and high leverage together. The Excessive Leverage of FIRI and the Fragile MUSI state are the same by definition.
This also explains how we can have periods of very high volatility but returns are still positive. If leverage is low then a deleveraging spiral doesn’t happen. So it does pay to buy on the dip it the Turbulent MUSI state. Not so much in the Fragile MUSI state where downside risk is high.
This text was adapted from a short note I had previously written. More in depth material will be available with the newsletter.
References
Minsky, H P, "The Financial Instability Hypothesis: A Restatement" (1978). Hyman P. Minsky Archive. Paper 180
