A Review of Hyman Minsky's Financial Instability Hypothesis 'Can It Happen Again' [Part V]:

The Workings of Tight Money:

Here Minsky discusses how tight money can work to restrain demand. Tight Money here is defined as "rising nominal interest rates associated with stricter other terms of contracts."

This he says may work to restrain demand in two ways;

- The Conventional View; here "tight money operates through rationing demand by means of rising interest rates."

- The Alternative View; this flows from the argument in the last section/thread on uncertainty, and "envisage tight money as inducing expectations, in the perceived uncertainty". This can be due to an episode of financial crisis or a period of financial stringency.

The way in which tight money operates will depend on the state of the economy. In a non-euphoric economy, where liability structures are somewhat satisfactory a monetary restraint would manifest itself by way of rationing.

In a Euphoric economic state, tight money will affect the economy only if it brings the financial structure to a halt from structuring and thining out liquidity due to changing expectations. The desire for liquidity surpasses the actual liquidity.

This state of euphoria is also characterised with increasing weights attached to the occurrence of natyre that favor the hlder or would be holder of capital assets and am upward drift in price flows.

Given this expectations, enterprises assumes that it can safely (i) undertake liabilities whose repayment is met by the "now-confidently expected cashflows", and (ii) undertake projects with expectations that futures cashflows will be a source of financing of the liability.

The weight attached to hold cash to ease liquidity strans is ever decreasing in this state.

 

The Existence of Lags between Money and Capital Market Conditions:

In a lagless world we're investment decisions are made with a clean slate current investment would equal current income expectations. But when lags are introduced investment spending reflects past decisions and the need for financing today can be "often inelastic".

Today's financing conditions can also affect investment spending decisions in the future. This pattern of Lags between the conditions in the capital market and investment spending is not independent of economic events and a dramatic financial market even can have a quick effect.

Tight Money means, units with outstanding debt would have to cover shortfalls in actual and expected income, by refinancing their debt or via outright sale of assets.

Deposit financial institutions he says, are especially vulnerable to tight money "if their assets are significantly longer than their debt". For banks, tight money means a detoriation in their financial position.

Furthermore in a euphoric economy the willingness or desire to hold cash decreases. The observed tightness is not necessarily caused money supply constraints, but a reflection of demands for money for financing.

The Theory of Financial Instability:

Now it has already been established that, normal functioning requires that that price level, should be consistent with the supply price of investment goods. A euphoric boom happens when portfolio preferences change such that the price of stock of real capital rises relative to the income level, causing an increase in the prices of outputs.

However, a "sharp fall in the price level of the stock of real capital will led to a marked decline in investment and  thus income" —this will typically occur under a period of changing expectations —a deeper recession he says, can occur only if a change in relative prices —from a change in the demand and future expectations— takes place.

Attributes of Stability:

In the last paper on uncertainty, it was held that an evaporation of confidence in views of future states of the economy previously held as the likelihood of possible states of the economy can cause a sharp decline in prices of existing stock of capital.

The event that would cause a change in portfolio preferences (and expectations) is "a period of financial crisis"

A financial crisis he said, is not an accidental effect, and so the interest here is in those attributes of the financial system that determine its stability.

The economy is best analyzed by assuming there exists more than one stable equilibrium. And the interest is the determinants of the domain of stability about these various equilibria.

Minsky expressed interest in answering two questions, what the maximum level of displacement that can take place and still have the economy return to stability, and upon what do these limit depend.

"The maximum shock that a financial system may absorb and still have the economy return to its initial equilibrium depend upon the financial structure and linkages between the financial structure and real income".

(This means the stability of the financial markets depends on the connection between financial sector -Banks, and other Financial Institutions- are linked to industry.)

What can trigger large depressive movements;

(i) a shortfall of cashflows from an overall decline in income, and (ii) distress in the system from an error of management.

So, not all recessions trigger financial instability, and not every financial failure triggers a panic or crisis. "For not unusual events to trigger the unusual, the financial environment within which the potential triggering event occurs must have a sufficiently small domain of stability"

The domain of stability of the financial system he argues is mainly an endogenous phenomenon, dependent on liability structures and institutional arrangements. The exogenous elements that determine financial stability consist of  Central Banking arrangements. As "after 1966 it became clear that exogenous policy instrument of deposit insurance is a powerful tool in offsetting events with the potential for setting off a financial crisis".

The Theory of Financial stability takes into account two aspects of capitalist economy behaviors. First, the evolution of financial structure over a long period of time which affects the nature of the primary assets, the extent of financial layering, and the evolution financial institutions and usages, and secondly, the financial impacts over short periods of time m, from a highly optimistic and Euphoric economy.

Financial Instability however is "as a system characteristics , compounded of two elements. How units are placed in financial distress and how does unit distress escalate into systemwide crisis".

The Banking Theory for all Units:

Here Minsky analyses all economic units as though they were banks. With the "essential characteristic" being that these units finance their positions by "emitting liabilities". He says! "A financial institution doesn't expect to meet the commitments stated in its liabilities by selling out its position, or allowing it's portfolio to run off", but that "refinance it's position.by emitting new debt."

Every unit has a functioning cashflow, he adds. And "the relation between functioning cashflow and refinancing opportunities on the one hand and the commitment embodied in liabilities determine condition under which the organizations can be placed in financial distress"

He went on to analyse these organizations (or economic units), from a defensive viewpoint, to determine what it would take to put these organizations in distress.

Solvency and Liquidity Constraints: Here he points that all economic units have a balance sheet, which contains data on the asset and liabilities of the organization from which "one may derive a net worth or owners equity for the unit."

The proximate goal for the business may likely be to maximize the owners equity a condition that "reflects the need to protect some minimum owners equity under the most averse contingency as to the state of the economy."

A unit is said to be solvent when the value of its net worth is positive. And Solvency and liquidity are conditions every private organization must fulfil. Any failure —or near failure —to fulfill these conditions "can lead to actions by others that affect profoundly the status of the organization.

Minsky points that Solvency and Liquidity are related by explaining that, first "the willingness to hold the debt of any organization depends in part upon the protection to the dent holder embodied in the unit's net worth." A decline in the organization's net worth can lead to a decreased willingness by debt holder to hold (or lend to) the firms debt.

This would lead to difficulties in refinancing debt positions. Hence liquidity problems can stem from what was initially a solvency problem.

Also, a net drain of cash from an organization could prompt the business to generate cash by a rapid sale of assets, if that happens, a sharp fall in asset prices occur, and a sharp drop in net worth takes place.

So three sources of declines in price levels of the stock of real capital is identified;

(i). A rise in the weight attached to the possibility of states of the economy that make it disadvantageous to hold real assets or financial assets whose value are tied to real assets. (ii). A fall in the value of assets from discounted prices due to uncertainty.

And (iii) a decline in the value of real assets as conditions in he financial markets change under which positions could be refinanced.

Modes of System Behavior:

Minsky distinguishes between three modes of system behavior that depend."upon how [ex post] savings are in fact affected by [ex post] investment. The offset [of investment] to savings considered include real private capital (inside assets) and government deficits (outside assets).

He follows that "the consolidated change in net worth in an economy over a time period equals the change in the value of inside assets plus the change in the value of outside assets." So "at any moment in time the total private net worth of the system equals the consolidated value of outside plus inside assets."

If the value of the outside assets are  almost independent of system behavior "the ratio of the value of outside to the value of total or inside assets in the consolidated accounts is one gross measure of the financial structure. (That is, the allocation of capital between outside assets —bonds and treasury bills — and inside assets —real cand financial assets, depict the financial structure of the economy)

He follows that, "the savings of any period are offset by outside and inside assets." And the ratio of outside to inside assets in the current offset to savings, compared to the initial ratio —at the begining of the base time period— will "determine the financial bias on current income". (This 'financial bias' is fueled by expectations of business managers under uncertainty.).

"Over a protracted expansion the bias in financial development is towards inside assets. This bias, he says, is compounded out of three (3) elements.

-current savings are allocated to private investment rather than to government securities, this leads to capital gains,  then,

-the capital gains "raise the market price of the stock of inside assets"—fixed capital and equities, the demand for even more capital at these levels to finance positions leading to increases in interest rates, and

-the interest rates increase lower the nominal value of outside assets (bonds and treasuries).

The above inevitably leads to an increased "vulnerability of portfolios to declines in market price of the constituent assets".

Unit and System Instability:

Financial instability occurs when the tolerance of the financial system to shocks has been tested and decreased significantly. This is usually over phenomena that accumulate over a prolonged boom. These are;

- the growth of financial payments relative to income payments,

- the decrease in the relative weight of outside (and guaranteed) assets in favor of inside assets, and

- the build up of financial structures that reflect a boom or euphoric expectations based on the success of the recent past.

Though poor management could lead to financial Instability of individual units, it may not be the cause of system instability. He says that"system Instability occurs when the financial structure is such that the impact of one units financial distress places other units in difficulty.

A general systemwide contributing factor to the development of a crisis would be a general decline in income. A high financial commitment - income ratio becomes the necessary condition for financial instability, and "a decline in national income would raise this ratio."

Attempts by units pressed for cash to sell off assets to meet commitments would affect other "quite liquid of solvent organisations and has a destabilizing impact upon the financial markets."

(An increase in the supply of capital assets to raise cash would put downward pressure on prices as explained prior above, and this would affect asset valuations on the balance sheet of even the most solvent companies).

Therefore, ",an"explosive process  that involves declining asset prices and income flows may be set in motion".

A key element in the escalation of financial distress to system Instability, he says, is "the appearance of financial distress among financial institutions".

However he argues that "the development of effective central banking which makes less likely a pass-through to other units of losses due to the failure of financial institutions should decrease the likelihood of the occurrence of sweeping financial instability that has characteristized history".

But Minsky was under no illusions as he snoted that this isn't a full proof strategy and there are other nuances.to the thought (of central banking).

He argues that "even if effective action by the central bank aborts a full-scale financial crisis by sustaining otherwise insolvent or illiquid organizations, the situation that made such abortive activity necessary will cause private liability emitters, financial intermediaries and ultimate holders of debt to desire more conservative balance sheet structures."

(That is the markets may in times of uncertainty favor outside assets over inside assets as explained above.)

This movement towards the more conservative sheets will lead to a period of relative stagnation.

From the analysis four (4) propositions are drawn;

1. The domain of stability of the financial system is endogenous and decreased during a financial boom.

2. A prior financial crisis is a necessary condition for a deep depression.

3. The Central Bank cannot and does have the power to abort a financial crisis.

4. But even if the financial crisis is aborted by the Central Bank policies, the "tremor that goes through the system during the abortion can lead to a recession". However this can be expected to be "milder and significantly shorter that the great depressions that have been experienced in the past".

Central Banking:

Modern Central banks he says have a two facet role. As a stabilization and growth inducing instrument of the government and the lender if last resort to the financial system.

The decentralization of the US roles of the US Fed he writes, made it possible for buck passing. However one result from the decentralization with the fact of financial usage and market evolution, is the fact that "there exist a perennial problem of defining the scope and functions of the various arms of the central bank."

When the peg was removed, the Federal Reserve undertook the responsibility of maintaining order and stability in the financial markets, by "maintaining orderly conditions in a key asset markets" which Minsky points is "an extension of the lender of last resort functions.

"If a financial crisis occurs, the Central Bank must abandon any policy of constraint" this means providing sufficient liquidity to the markets to avert or cushion the shock or impending crisis.

Perhaps he says, "the optimal way to handle a euphoric economy is to allow a crisis to develop —so that the portfolios acceptable under euphoric conditions are found to be dangerous—but to act before any sever losses in market values".

If monetary conditions are eased prematurely it could lead to a resurgence in the euphoric expansion. If eased after the beginning of a crisis, the effect excessive of the lender of last resort, prevents too great a fall in asset prices such that a debt deflation is enacted.

The euphoria will be terminated and a more sustainable environment—in terms of investment demand between capital stock and desired capital— will be established.

If the lender of last resort is too late or too little, then "the decline in asset prices will lead to a stagnation of investment and a deeper and more protracted recession.

If Capitalism reacts to past success, he says, by trying to explode, "it may be that the only effective way to stabilize the system, short of direct investment controls, is to allow minor financial crises to occur from time to time".

The lender of last resort responsibilities having been modified over the years, to allow minor financial crisis to occur whilst sustaining asset prices against large declines, make for an arena where "humans error plays a significant role in determining actual economic outcomes"

He concludes stating that: Central banks only have much acpe in a "taut, euphoric and potentially explosive economy". The importance he attaches to human error is "due to a system characteristic— the tendency to explode—rather than failings of the board of Governors"