Theory of Financial Crises in a Global Contex

Minsky’s Theory of Financial Crises in a Global Context
Author(s): Martin H. Wolfson
Source: Journal of Economic Issues, Vol. 36, No. 2 (Jun., 2002), pp. 393-400
Published by: Association for Evolutionary Economics
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J JOURNAL OF ECONOMIC ISSUES
Vol. XXXVI No. 2 June 2002
Minsky’s Theory of Financial Crises in a Global Context
Martin H. Wolfson
Hyman Minsky’s theory of financial crises was developed in the context of a domestic
economy. Recent financial instability in the international economy, however, suggests
that it would be useful to examine his theory in a more global environment. After briefly
discussing the main themes of Minsky’s domestic theory in the first section, this paper
then attempts to identify how the theory would need to be modified to take account of
the international setting. In the last section, institutional changes in the global economy
are investigated and their relevance to financial crises is evaluated in light of the theory
discussed in the second section.
Main Themes of Minsky’s Domestic Theory of Financial Crises
For our purposes here, we will consider Minsky’s theory under the following headings: the systemic development of financial fragility; the movement to the brink of
financial crisis; the disruption of stability by a “not unusual” (surprise) event; and
debt-deflation, including the ability to prevent the debt-deflation process.
The Systemic Development of Financial Fragility
Minsky’s theory of financial crises is set within the context of an expanding economy. As the expansion develops, optimism increases, and conventions about the proper
level of debt and risk begin to change. Prices of financial assets rise and the general level
of speculation increases. Speculation is taken to be the attempt to bet on the future
direction and psychology of the market (Keynes 1936, 158), and also the more general
The author is in the Department of Economics, University of Notre Dame, Indiana, USA. This paper was presented at the
annual meeting of the Association of Evolutionary Economics in Atlanta, Georgia, USA, January 4-6, 2002.
393
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394 Martin H. Wolfson
process of financing assets whose value depends on future developments (Minsky 1975,
120-23).
As attitudes about risk and proper liability structures change, the financial system
becomes increasingly fragile. Minsky’s view is that fragility grows as debt levels increase,
the proportion of short-term debt rises, liquidity declines, and speculative and Ponzi
firms (see below) increase (Minsky 1977, 142). The proportion of short-term debt
increases as firms take advantage of a normal yield curve, in which long-term interest
rates are higher than short-term rates. “With such a rate pattern, one can make on the
carry by financing positions … in long-term financial assets by short-term, presumably
liquid, debts” (Minsky 1986, 211).
The terms hedge, speculative, and Ponzi finance are used to indicate the relative difficulties that economic units have in repaying debt. The classifications revolve around the
relationship between cash receipts due to normal operations and cash payment liabilities due to debt. A hedge firm is able to meet all cash payment liabilities with cash
receipts. A speculative firm, however, has difficulty meeting some payment liabilities,
usually those coming due in the short term. Typically, a speculative firm will have to refinance some short-term liabilities. A Ponzi firm has the most difficulties; it must borrow
to meet current interest payments. Thus a Ponzi firm is continually increasing its outstanding debt.
The Movement to the Brink of Financial Crisis
Minsky argued that there would be a tendency for speculative and Ponzi units to
increase, in relation to hedge units, with an increase in interest rates: “speculative and
Ponzi-finance units are vulnerable to changes in interest rates … increases in interest
rates will raise cash-flow commitments without increasing prospective receipts” (Minsky
1986, 209). The Federal Reserve, by increasing interest rates in the context of tightening
monetary policy, has thus been in the position of actually worsening financial conditions: “The Federal Reserve can bring a halt to an inflationary process only as it forces
high enough interest rates so that units which need refinancing are found to be ineligible for financing . .. Since the mid-1960s the Federal Reserve has been able to force a
contraction only as it has taken the economy to the brink of financial crisis” (Minsky
1982, 199).
The Disruption of Stability by a “Not Unusual” (Surprise) Event
In such a vulnerable situation, a “not unusual” event is capable of initiating a financial crisis. Since the future is uncertain, if such an event, like a failure of a large company
or bank, suddenly occurs, the optimistic expectations that had developed during the
boom are subject to significant revision (Crotty 1994). These events are surprises in the
sense that they cannot be predicted. However, “the fragility of the system makes the
appearance of such a surprise event likely. . . the existence of such an event should best
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Minsky’s Theory of Financial Crises in a Global Context 395
be understood as an … endogenous reaction to the pressures building in the financial
system” (Wolfson 1994, 147).
Debt-Deflation
In Minsky’s view, the financial crisis leads to an increased unwillingness to finance
investment. The decline in investment spending negatively affects profits, which only
worsens the difficulties in meeting debt payment commitments. At this point the possibility arises of a debt-deflation process, in which defaults on debt payments lead to a
decline in aggregate demand, which reduces prices, increases the real value of outstanding debt payment commitments, and accelerates the interacting downward spiral
(Fisher 1933).
The debt-deflation process, however, has not taken place in the United States since
the Great Depression. According to Minsky, two developments have kept the debt-deflation process at bay: a big bank and a big government. The Federal Reserve, by intervening as a lender of last resort, has been able to stabilize financial markets and keep the
financial crisis from worsening. And increases in the federal budget deficit, by stimulating aggregate demand and sustaining business profits, have prevented the debt-deflation
process from developing.
Minsky emphasized, though, that lender of last resort operations and prevention of
the debt-deflation process are not sufficient. In order to reduce the likelihood of a financial crisis and potential debt-deflation from reappearing, policymakers need to rein in
the financial innovations, practices, and attitudes that had led to the past bout of exuberant financing. “If the lender-of-last-resort interactions are not accompanied by regulations and reforms that restrict financial market practices, then the intervention sets
the stage for the financing of an inflationary expansion, once the ‘animal spirits’ of business people and bankers have recovered from the transitory shock of the crisis” (Minsky
1982, 198-99).
Minsky’s Theory in a Global Context
How would Hyman Minsky’s theory of financial crises have to be modified to take
account of the international economy? In what follows, this issue is addressed.1
Throughout, the exemplar for a global financial crisis is taken to be the Asian financial
crisis, although financial crises involving the international financial system can develop
in other ways as well.2
Obviously, a key issue in extending the domestic theory is the possibility that
money from one country can be lent or invested in another country. In the prelude to
the Asian financial crisis, lending and investment to “emerging markets” became the
hot new area in the 1990s. Partly as a result of the recession and falling interest rates in
the United States and other developed countries in the early 1990s, billions of dollars
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396 Martin H. Wolfson
flowed to countries in Asia, to lend to Asian banks and businesses and to invest in Asian
financial markets. As profits grew, expectations of further profits expanded, which led
to further flows of funds, in a speculative, endogenous development of expectations,
confirming Minsky’s perspective. As debt was extended and speculative investment
expanded, financial fragility in the Asian countries increased. However, without the
ability to cross national borders, it is unlikely that financial fragility would have developed as rapidly as it did.
Of course, the importance of the ability of funds to cross national borders can be
reduced if there are limited opportunities for investment of foreign funds in domestic
financial markets. Thus what is also necessary for financial fragility to develop in this
way is a lack of regulations and laws limiting foreign financial investment.
As funds poured into Asian markets, few investors thought it was necessary to
hedge these investments, since exchange rates in these countries had been stable. The
speculative bet that exchange rates would remain stable proved to be an expensive error.
Thus, in addition to the characteristics of domestic financial fragility mentioned by
Minsky, we should consider exchange-rate risk to be an aspect of financial fragility in the
global environment.
For Minsky, an important component in the development of financial fragility is an
increase in speculative and Ponzi finance. One important source of the financial vulnerability implied by speculative and Ponzi finance is the increasing attraction of “making
on the carry” by borrowing at relatively low short-term rates and lending at high
long-term rates. Financial institutions used this device in the Asian financial crisis by
borrowing in countries in which interest rates were low, such as Japan, and lending in
other Asian countries, in which interest rates were higher. It was termed the “carry
trade.”
However, if loans are extended by financial institutions in one country to borrowers in another country, what becomes increasingly relevant for borrowers is the stance of
monetary policy, and the direction of interest rates, in the country from which the loans
are being made. Apparently, the rumor of increasing interest rates in Japan was a precipitating factor in the Asian financial crisis, as profits from the carry trade were threatened.3
In addition to increases in interest rates in foreign countries, changes in exchange
rates can also make it more difficult to repay debt. If international loans are made in
hard currency, then a fall in the domestic currency against the hard currency can
increase the amount of domestic currency borrowers must earn in order to repay their
loans. Although the Asian countries went to great lengths to keep their currencies from
falling, the pressure put on the currencies from capital fleeing from Asia ultimately
broke the pegs.4
As financial fragility worsens, Minsky contended that a “not unusual” event is capable of initiating a financial crisis, which Minsky identified with the forced selling of
assets to raise cash and sharp declines in the price of assets (Minsky 1977, 140). In the
context of the global economy, a development of interest is the spread of financial crises
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Minsky’s Theory of Financial Crises in a Global Context 397
from one country to another. In Asia, the financial crisis began in Thailand. However,
since financial fragility had developed in other Asian countries as well, when investors
fled Thailand, it was perhaps to be expected that they would flee the other countries as
well. This “contagion” effect proved to be the initiating event for financial crises in the
other countries.5
As investors fled financial markets in Asia and as exchange rates fell, the pressure
on domestic borrowers to repay debts in hard currency intensified, as noted above. As
falling exchange rates increased the real value of debt repayment in hard currency, more
borrowers were unable to meet debt payment commitments, and more loans were
defaulted. As loan defaults mounted, the momentum to flee intensified. Loans were not
rolled over or renegotiated, investors fled financial markets, and the exchange rate fell
further. Thus an interactive process developed that ultimately spiraled downward and
intensified the crisis, a process very much like the debt-deflation process at the domestic
level.
As discussed above, Minsky observed that one way to stop a debt-deflation process
was by means of a big bank acting as a lender of last resort. The obstacle, however, to central banks in Asia acting as a lender of last resort was the need to repay loans in hard currency. Although Asian central banks could act as a lender of last resort in domestic
currency, this would not help borrowers who had debt obligations in US dollars or yen.
Because there was not a central bank that was prepared to act as a lender of last resort on
a global level, the debt-deflation process in Asia intensified.
In Minsky’s theory of financial crises, the other intervention that helps to restrain
the debt-deflation process is big government. Of course, at the international level, there
is no central government. By coordinating macroeconomic policy to stimulate aggregate
demand, though, governments could approximate the role that Minsky suggests.6 However, this did not happen after the Asian financial crisis.
The primary response to the Asian financial crisis at the international level was the
intervention of the International Monetary Fund. But, as Jan Kregel (1998a) pointed
out, the IMF’s intervention only made the situation worse. Rather than providing a
floor to aggregate demand, the IMF mandated policies that reduced aggregate demand.
We can summarize the above argument as follows: Minsky’s theory can be modified
so that, in a global context, financial fragility is increased by the ability of funds to cross
national borders and invest in domestic markets; an increase in exchange-rate exposure; and global
interest-rate speculation, such as the “carry trade.” The movement to the brink of financial
crisis can come about from increases in foreign interest rates and decreases in exchange rates.
The “not unusual” event can be contagion, and debt deflation can take the form of a
debt-exchange-rate inraction. The debt deflation can be worsened by the absence of a global
central bank, the absence of coordinated macroeconomic policy, and intervention that reduces
aggregate demand.
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398 Martin H. Wolfson
The Institutional Setting of Minsky*s Global Theory
Hyman Minsky, as a Post Keynesian institutionalist, took the institutional setting
of his theory seriously. Therefore it would be useful to consider some of the changes that
have taken place in the institutional environment of the international financial system
that are relevant to Minsky’s theory of financial crises in a global context. Three are especially important.
First, there has been a wholesale removal of capital controls in the global economy
and, second, there has been a significant increase in the financial deregulation of
domestic financial markets. Both of these developments are an aspect of the neoliberal
agenda of eliminating regulations and promoting the mobility of capital (Wolfson
2000). However, since it was noted above that financial fragility is increased by the ability of funds to cross national borders and the ability to invest foreign funds in domestic
markets, it is clear that opening up countries to foreign capital has likely led to increased
financial crises (see also Gray and Gray 1994).
The third development concerns the role of the multinational agencies, especially
the International Monetary Fund. The IMF is in the position of being able to intervene
with hard currency in the wake of crises. With that ability, it could conceivably function
as a lender of last resort. However, as noted above, the policy prescriptions imposed by
the IMF as a condition of receiving funds have required the receiving countries to
reduce aggregate demand, through monetary and fiscal austerity. As Kregel (1998b)
demonstrated, these policies misidentified the financial crisis in Asia as a balance-of-payments problem and only served to worsen the debt-deflation problems of the Asian
countries.
But an important aspect of the role of the IMF has been to enforce the neoliberal
agenda. Policy prescriptions in the 1980s and 1990s, and continuing into the present,
have aimed at reducing government’s role in the financial system and introducing “market friendly” policies wherever possible. Minsky’s view consistently has been that a free
market capitalism is likely to lead to financial crises and, indeed, even to debt-deflations
and depressions: “A sophisticated, complex, and dynamic financial system such as ours
endogenously generates serious destabilizing forces so that serious depressions are natural consequences of noninterventionist capitalism: finance cannot be left to free markets” (Minsky 1986, 292).
Does this conclusion also apply when Minsky’s theory is modified to take account
of the global context? To the extent that institutional changes in the international economy have reduced restrictions on the free market, it may be the case that we are
approaching a situation in which the global economy can be considered a closed system
of capitalist finance. Greater capital mobility, and the increasing ability to lend and
invest anywhere in the world, have eroded some of the important differences between
domestic and international dynamics. Thus we would expect that, despite a need to still
take account of differences in exchange rates and national macroeconomic policies, the
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Minsky’s Theory of Financial Crises in a Global Context 399
systemic processes of a capitalist financial system, as analyzed by Minsky, would be evident on the global stage.
Minsky, though, was hopeful that regulations and appropriate policies could
restrain the worst excesses of a free-market economy. That was the premise, of course, of
one of his major books: Stabilizing an Unstable Economy. As he noted in that work, “the
financial instability theory points out that what actually happens changes as institutions
evolve, so that even though business cycles and financial crises are unchanging attributes of capitalism, the actual path an economy traverses depends upon institutions,
usages, and policies” (Minsky 1986, 174-75). Based on the analysis above, we would
expect that reforms along the lines of capital controls, regulation of domestic financial
markets, and a true global lender of last resort would be in order.
However, policy makers at the IMF, World Bank, US Treasury, and other centers
of power have continued to resist this message, despite rising worldwide protest and
some high-placed dissent.7 Rather than using the opportunity following the Asian financial crisis to restrain the excesses that had led to the crisis, policymakers pushed ahead
with their free-market agenda. Ultimately, then, the implication of Minsky’s theory in a
global context is that financial crises and debt-deflations will be the continuing legacy of
the attempt to eliminate all restrictions on the free market.
Notes
1. The intention is not to present a fully developed theory of global financial crises. Rather, the
more modest aim is to suggest some issues that would need to be considered in order to begin
to develop a more global theory.
2. For example, failed foreign-exchange speculation by the Franklin National Bank, with headquarters in Long Island, New York, disrupted the Eurodollar interbank market in 1974
(Wolfson 1994, 56-59). Also, given the international interconnectedness of banking and
financial markets, especially with the growth of derivatives, a disruption in any part of the system has the possibility of having global ramifications.
3. Also, actual increases in interest rates by the Federal Reserve in the early 1980s were instrumental in negatively impacting Mexico’s ability to repay commercial bank loans in 1982, and
ultimately bringing about the Latin-American debt crisis.
4. It is probably necessary to put decreases in the exchange rate in context. A gradual decline is
not likely to be as disruptive as a pegged exchange rate that is suddenly abandoned. Also, the
effect of a decline in the exchange rate on the trade balance, and thus the ability to earn foreign exchange, should be taken into account.
5. A similar effect was observed following the stock market crash in the United States in 1987.
Soon stock markets around the world were affected by a similar contagion effect.
6. Peter Gray and Jean Gray (1994) suggested that an international hegemon could act to restore
stability, but currently there is no country playing that role.
7. Even Nobel laureate Joseph Stiglitz was unable to sway these policymakers (Stiglitz 2000).
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400 Martin H. Wolfson
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Fisher, Irving. “The Debt-Deflation Theory of Great Depressions.” Econometrica 1, no. 4 (October 1933),
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Keynes, John Maynard. The General Theory of Employment, Interest, and Money. New York: Harcourt, Brace, 1936.
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