Reading 8 – The natural instability of financial markets – Jan Kregel
About Minsky’s financial instability hypothesis: fragility inherent to successful functioning of
capitalist economies + takes the US financial system = as its reference structure.
- Fragility = result from changes of liquidity preferences of businessmen + bankers for a given
a degree of maturity mismatching.
- Regulations = useful to preventing not fragility per se (which is inevitable for successful
functioning of capitalism) but its propagation to avoid situations like: debt deflations
(occurred in 1930s = Great Depression).
Financial transactions = decisions (like: exchange of money) made today based on expectations
about tomorrow + only if expectations = correct will the future transactions be realized =
assumption of Rational Expectations.
Keynes it is the expectation of uncertain future events that determine present decisions to enter
into economic activity SO problem is: HOW to prevent these natural transactions failures due to
uncertainty that would cause chronic instability??? 3 theories on how:
1) Classical theory of economic policy: need of government to provide a regulatory framework to
avoid the chaos that would result from self-interested behavior (Lionel Robbins referring to Smith +
Ricardo)
2) extension of Efficient Market paradigm (adopted by Federal Reserve) to spread risk on those who
can bear it
3) Minsky’s financial instability theory following Keynes agreed results of transactions = inherently
uncertain + went further also: creation of fragility + instability = endogenous process economic
stability makes the economy more and more fragile + neither regulations nor complete perfect
market could ensure financial stability instead = cause of instability!!
Minsky’s hypothesis developed during the “golden years” of New Deal legislation = period of
economic stability clearly Minsky saw in this stable period an increasing fragility of the economy
and so to him the New Deal did little to avoid instability clearly financial regulation and fragility
are independent (as shown by this period) BUT financial regulation can play a role in the propagation
of fragility and therefore in causing instability.
Minsky argued: that the risk of fragility breaking down to instability = prevented by
- “Big Government” = acting as lender of last resort for households + businesses
- “Big Bank” = acting as a lender of last resort for financial institutions
BUT this method of avoiding instability = not available at global level not possible to
have a:
1. global government = to provide anti-cyclical fiscal policy.
2. global central bank = to act as a lender of last resort
FINANCIAL INSTABILITY AND FINANCIAL FRAGILITY
Financial institutions = intermediators between saver lending funds + borrowers investing the funds
Intermediation requires:
- matching borrowers+ lender
, - matching their concerns about the transformation of the maturity of financial assets from
short-term to long-term
implicit assumption: lenders prefer short-term liquid assets + borrowers prefer: long-
term, more permanent, fixed interest liabilities the greater the mismatch = the greater
the risk of insolvency (= greater the mismatch between: maturity of short-term assets issued
to savers + long-term liabilities purchased from investors = greater the risk that an increase
in short-term interest rates relative to long-term rates will produce negative net worth +
insolvency)
when volatility of short-term interest rates = modest adjustment consists of: cutting
back on new lending + reducing net margins + drawing down secondary reserves (= method
of monetary control in post-war period)
when volatility of short-term interest rates = substantial loans must be called (repaid)
+ forced sales of assets which leads to downward pressure on asset prices.
Financial institutions = characterized not only by (1) intermediary role + (2) maturity transformation
concerns but also (3) produce liquidity issuing short term liabilities against long term assets:
banks can create liquidity making an illiquid asset more liquid while the bank itself becomes less
liquid willingness of the bank to create liquidity via lending for (against) a private sector held
asset (= willingness to finance an investment project) = depends on “liquidity preferences” of the
bank the bank charges a
price for such liquidity creation = “liquidity premium”
Financial institutions = 2 features:
1. maturity intermediation
2. liquidity creation
= these 2 are linked together banks lend against real assets by creating demand
deposits
In neoclassical efficient market hypothesis = maturity transformation does not create additional
liquidity
In Minsky = financial fragility not only = possibility of maturity mismatching BUT inherent to
successful operation of capitalist economies + results from changes in liquidity preferences of
bankers/businessmen = represented as changes (produced by maturity transformation) in the
margins of safety required for liquidity creation (= for lending).
SO: fragility can be present even in a stable economy due to changes in the extent of creation of
liquidity for a given degree of mismatching
in this case then: a fall in fall in liquidity preference can take place + while maturity mismatching
remains constant as bankers = more willing to lend against riskier assets.
FRAGILITY IN STABLE CONDITIONS
Minsky’s theory: refers to the US financial system + to the banks of the 1960s (= subject to the Glass-
Stegall Act on restrictions on commercial banking + before the breakdown of the Bretton Woods
system)
Finance for businessman = 2 stage affair:
- 1. Short term financing of projects comes from the bank.
About Minsky’s financial instability hypothesis: fragility inherent to successful functioning of
capitalist economies + takes the US financial system = as its reference structure.
- Fragility = result from changes of liquidity preferences of businessmen + bankers for a given
a degree of maturity mismatching.
- Regulations = useful to preventing not fragility per se (which is inevitable for successful
functioning of capitalism) but its propagation to avoid situations like: debt deflations
(occurred in 1930s = Great Depression).
Financial transactions = decisions (like: exchange of money) made today based on expectations
about tomorrow + only if expectations = correct will the future transactions be realized =
assumption of Rational Expectations.
Keynes it is the expectation of uncertain future events that determine present decisions to enter
into economic activity SO problem is: HOW to prevent these natural transactions failures due to
uncertainty that would cause chronic instability??? 3 theories on how:
1) Classical theory of economic policy: need of government to provide a regulatory framework to
avoid the chaos that would result from self-interested behavior (Lionel Robbins referring to Smith +
Ricardo)
2) extension of Efficient Market paradigm (adopted by Federal Reserve) to spread risk on those who
can bear it
3) Minsky’s financial instability theory following Keynes agreed results of transactions = inherently
uncertain + went further also: creation of fragility + instability = endogenous process economic
stability makes the economy more and more fragile + neither regulations nor complete perfect
market could ensure financial stability instead = cause of instability!!
Minsky’s hypothesis developed during the “golden years” of New Deal legislation = period of
economic stability clearly Minsky saw in this stable period an increasing fragility of the economy
and so to him the New Deal did little to avoid instability clearly financial regulation and fragility
are independent (as shown by this period) BUT financial regulation can play a role in the propagation
of fragility and therefore in causing instability.
Minsky argued: that the risk of fragility breaking down to instability = prevented by
- “Big Government” = acting as lender of last resort for households + businesses
- “Big Bank” = acting as a lender of last resort for financial institutions
BUT this method of avoiding instability = not available at global level not possible to
have a:
1. global government = to provide anti-cyclical fiscal policy.
2. global central bank = to act as a lender of last resort
FINANCIAL INSTABILITY AND FINANCIAL FRAGILITY
Financial institutions = intermediators between saver lending funds + borrowers investing the funds
Intermediation requires:
- matching borrowers+ lender
, - matching their concerns about the transformation of the maturity of financial assets from
short-term to long-term
implicit assumption: lenders prefer short-term liquid assets + borrowers prefer: long-
term, more permanent, fixed interest liabilities the greater the mismatch = the greater
the risk of insolvency (= greater the mismatch between: maturity of short-term assets issued
to savers + long-term liabilities purchased from investors = greater the risk that an increase
in short-term interest rates relative to long-term rates will produce negative net worth +
insolvency)
when volatility of short-term interest rates = modest adjustment consists of: cutting
back on new lending + reducing net margins + drawing down secondary reserves (= method
of monetary control in post-war period)
when volatility of short-term interest rates = substantial loans must be called (repaid)
+ forced sales of assets which leads to downward pressure on asset prices.
Financial institutions = characterized not only by (1) intermediary role + (2) maturity transformation
concerns but also (3) produce liquidity issuing short term liabilities against long term assets:
banks can create liquidity making an illiquid asset more liquid while the bank itself becomes less
liquid willingness of the bank to create liquidity via lending for (against) a private sector held
asset (= willingness to finance an investment project) = depends on “liquidity preferences” of the
bank the bank charges a
price for such liquidity creation = “liquidity premium”
Financial institutions = 2 features:
1. maturity intermediation
2. liquidity creation
= these 2 are linked together banks lend against real assets by creating demand
deposits
In neoclassical efficient market hypothesis = maturity transformation does not create additional
liquidity
In Minsky = financial fragility not only = possibility of maturity mismatching BUT inherent to
successful operation of capitalist economies + results from changes in liquidity preferences of
bankers/businessmen = represented as changes (produced by maturity transformation) in the
margins of safety required for liquidity creation (= for lending).
SO: fragility can be present even in a stable economy due to changes in the extent of creation of
liquidity for a given degree of mismatching
in this case then: a fall in fall in liquidity preference can take place + while maturity mismatching
remains constant as bankers = more willing to lend against riskier assets.
FRAGILITY IN STABLE CONDITIONS
Minsky’s theory: refers to the US financial system + to the banks of the 1960s (= subject to the Glass-
Stegall Act on restrictions on commercial banking + before the breakdown of the Bretton Woods
system)
Finance for businessman = 2 stage affair:
- 1. Short term financing of projects comes from the bank.
