Lesson 6 of 8
Stability breeds instability
Two theorems and three financing postures. A long calm moves borrowers along the scale until the system amplifies deviations rather than damping them.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Three financing postures: hedge, where cash flows cover interest and principal; speculative, where they cover interest only; and Ponzi, where they cover neither.
- Two theorems: an economy has financing regimes under which it is stable and regimes under which it is not, and prolonged prosperity moves it from the first to the second.
- The instability is internal. No shock from outside is needed, and no central bank error is required, which is the sharpest difference from the account in this track.
Minsky's hypothesis is the rival account closest to the one this track teaches, and the closeness makes the differences worth stating carefully. The compact statement used here is a 1992 working paper written for a handbook.
The three financing postures
Hedge and speculative
- Hedge: cash flows from operations cover interest and principal.
- The more equity in the liability structure, the likelier this is.
- Speculative: cash flows cover the income payments but not the principal.
- Such units must roll over liabilities as they mature.
Ponzi, and why the label is technical
- Cash flows cover neither principal nor the interest due.
- The unit sells assets or borrows to pay interest.
- Each such payment lowers equity and raises liabilities.
- The margin of safety offered to lenders falls as this continues.
A unit's posture is a fact about its balance sheet that can change without the unit doing anything.
The two theorems
The first theorem is that the economy has financing regimes under which it is stable and financing regimes under which it is not. Where hedge financing dominates, the system tends to seek and hold equilibrium; the greater the weight of speculative and Ponzi units, the more it amplifies deviations.
The second is the one the hypothesis is famous for. Over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge units to one with a large weight of speculative and Ponzi units. Stability itself changes the distribution of financing postures, because a calm period makes the riskier posture look reasonable.
Minsky adds a specific trigger. If an economy with many speculative units is inflating and the authorities tighten to stop it, speculative units become Ponzi units and the net worth of existing Ponzi units evaporates quickly. Units short of cash are forced to sell assets to make position, which is how a collapse of asset values begins.
How close it is to the account in this track
Both accounts have a boom that creates its own reversal rather than being ended by an outside event. Both make credit central and treat the balance sheet as the place where trouble accumulates. Both predict that a long expansion leaves the system more fragile than it looks.
Three differences are real.
The mechanism here is financial rather than structural: what changes over the boom is the composition of liabilities, not the time profile of the capital stock. Nothing in the hypothesis requires that resources are drawn toward activities remote from consumption.
The driver is endogenous optimism rather than a policy rate below a natural level. No central bank error is needed, and Minsky's system is unstable on its own account.
And the conclusion drawn from it is different. Minsky's framework treats interventions and regulation as part of the system that keeps the economy within bounds rather than as the source of the disturbance. This course does not take a position on that, and notes only that the two accounts do not share one.
Why an investor cares
Because the three postures are readable in a filing. Whether operating cash flow covers interest, whether it covers scheduled repayments, and whether the company is borrowing to pay either, are questions the statements answer directly.
That is the only place in this track where a cycle theory turns straight into a line on a balance sheet, and it is the reason Minsky is read by practitioners who have never read anything else in this course.
Check yourself
What is a speculative unit, in this classification?
- One that invests in risky assets
- One whose cash flows cover interest but not principal, so it must roll over its liabilities
- One that has no debt
Show the answer
Answer: B.
The classification is about contractual payments against expected cash flows. Banks and firms with commercial paper programmes are given as ordinary examples.What is the second theorem of the hypothesis?
- That asset prices always revert to fundamentals
- That over a protracted period of good times the financial structure moves from hedge toward speculative and Ponzi finance
- That central banks always tighten too late
Show the answer
Answer: B.
That is the sense in which stability breeds instability: the calm period itself changes the distribution of financing postures.What is the sharpest difference from the account in this track?
- Minsky ignores debt
- The instability is internal and financial, needing no policy error and no change in the time structure of production
- Minsky denies that booms end
Show the answer
Answer: B.
The mechanism is the composition of liabilities rather than the composition of capital, and no central bank mistake is required to set it going.Sources
- Minsky, 'The Financial Instability Hypothesis', Levy Economics Institute Working Paper 74, May 1992, prepared for the Handbook of Radical Political Economy, edited by Arestis and Sawyer, published by Edward Elgar in 1993: the three financing postures and their definitions, the two theorems, the effect of monetary tightening on speculative and Ponzi units, the forced selling that follows, and the statement that the hypothesis does not rely on exogenous shocks.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- Minsky's own account is heterodox too, from a different direction. It is presented here as a rival explanation, not as a mainstream consensus.
- The company example is invented to show how a posture changes. It describes no company, and nothing here is a judgement about any company's financing.