Minsky: Financial Instability Hypothesis

In the 1970s and later, the efficient market hypothesis led by Eugene Fama and Robert Lucas attracted both academic interest and was generally accepted as true. However, Hyman P. Minsky, who had started working on the financial instability hypothesis in the 1950s, opposed the efficient market hypothesis.

Source:https://en.wikipedia.org/wiki/Hyman_Minsky

According to Minsky, the efficient markets hypothesis did not focus the concepts of money and finance sufficiently. Within the complex structure of a modern capitalist economy, money and finance had a greater importance than the efficient markets hypothesis thought. Money, which is treated neutrally in many schools of economics, is not neutral in Minsky's financial instability hypothesis.

Minsky was an academic with a mathematical education. However, he did his studies in the field of economics. He lived during the Great Depression that started in 1929 and was influenced by JM Keynes. Although he received a mathematical education, he did not study economics with intensive mathematical formulas during the period when economics was developed with intensive mathematical approaches.

Minsky explains the financial instability hypothesis with the concept of investment. The profit of an investment made today will emerge in the future through the activities of a business. There can be two sources of investment made today: a firm's own cash source or cash value provided by debt. The point at which the balance between these two sources can provide optimality is an important topic of discussion.

Minsky analyzed the financial opportunities provided for an investment under three different classifications.

Financing a company's investment with its own resources (hedge financing): This method is the payment of a company's debts with the resources it provides from its own activities and future cash flows. Minsky sees this method as the safest financing method. Because the repayment of the debt is based on the profits to be obtained in the future. The financing provided with this method will keep the debt level of a company low.

Speculative financing: A company uses future cash flows from its operations for interest payments while repaying the financial resources it provided today. However, the financial resource must be reused for the principal repayment. Providing financing with this method is riskier than the first method mentioned above. In order for the principal repayment of the provided financing to be realized, macroeconomic conditions must be in a positive conjuncture. An economy in recession or depression may not be able to reuse the principal.

Ponzi financing: A situation where a company does not use the future cash flows it will obtain from its activities for either interest or principal when repaying the financial resources it provides today. This is a financing that is implemented based on the assumption that the asset that is the basis for the provision of the financial resource can be of a value that will make both interest and principal payments until the maturity of the debt. However, there is a risk that the asset in question will not be able to make both interest and principal payments at the maturity of the debt. The macroeconomic conjuncture is the basic element that will determine the value of the asset.

The financing conditions described above are listed by Minsky, ranked from the lowest risk to the highest risk. The failure of one of the parties, the lender and the borrower, to fulfill its obligations, which are the conditions of the debt, is a risk for the financial system. If a party that suffers financial losses due to the failure of one of the parties to the debt fails to fulfill its obligations, and the other party fails to fulfill its obligations, a systemic risk is likely to emerge.

As systemic risks emerge and the financial structure becomes unable to carry more risk, asset prices will begin to fall. Every asset that is subject to debt represents a claim on the future cash flows of a firm from the perspective of the party providing the financial resource. The value of an asset is directly proportional to the realization of future cash flows. The spread of risks related to the payment of debts in market conditions will lead to a successive decline in asset prices systematically. Irving Fisher called this process debt deflation. The aggravation of the conditions of the Great Depression that emerged in 1929 occurred under debt deflation conditions.

In economies, the financing of investments mainly through the first method defined by Minsky as mentioned above is a risk reducing element in terms of macroeconomic balance. Financing investments through the use of the other two methods and especially through Ponzi financing will expose economies to high systemic risks. The decrease in asset prices due to monetary tightening or external shocks will initiate a process in which especially firms with adverse financial conditions will start to sell their assets. Such a development will bring about a new process of decrease in asset prices and create a negative spiral.

The process has resulted in high dependency, especially for developing countries, and has also turned income inequality into a major problem worldwide. The economic damage caused by income inequality has become a frequently analyzed topic in economics literature.