The Minskyian Model of Economic CrisesPosted: July 27, 2015
Minskyian economic theory directly links an oscillating aggregate supply of credit in an economy to the potential for economic crisis. It suggests that credit supply has a cyclical nature in highly financial economies. Thus the seeds of crisis are endogenously sown during seemingly productive booming previous periods. This piece will describe the model’s principles and note how its theories stray from mainstream economic thought. This analysis will come in useful in future posts, as the model seems to well approximate numerous historical crises – and of current importance: the ongoing travails of the Chinese economy in 2015.
The model has three theoretical principal underpinnings: Keynesian uncertainty, unreliable knowledge and the principle of increasing risk. An environment of Keynesian uncertainty greatly diverges from much of neoclassical thought by suggesting economic actors are neither able to instantaneously nor perfectly assign mathematical probabilities to future events. By extension, actors are thus unable to accurately aggregate the likelihood of multiple events with any accuracy. This is closely related to the second principal – that actors operate with incomplete and imperfect information. Again the strays from neoclassical thought where, via mechanisms like the Efficient Markets Hypothesis, the mainstream suggests that actors have perfect knowledge of the entire economy through market prices. Thirdly, the principle of increasing risk suggests that the economy becomes increasingly more fragile as the level of debt in the economy increases. This is because collapses become more common and have greater macroeconomic impact as debt relationships interlink the economy.
A Minskyian Collapse
The narrative begins during the final stages of a previous economic crisis – Stage 1 in the diagram. After an economic crisis, the supply of credit in the economy begins to bottom-out. This is because lenders are highly cautious due to the recent memory of painful failed loans and general economic risks making returns on investment difficult to forecast. Thus they alternatively favour “safe” investments like Treasury Bills or making the cost of money so high relatively that risky borrowers are priced out of the market. These two example paths are key because they ensure that borrowers can only undertake “safe” investments, where investment revenue will exceed debt repayments. Else wise, investment is generally funded by retained earnings or internal financing.
As we move into Stage 2 of the diagram, many of the characteristics of lenders and borrowers have remained constant – i.e. being generally cautious and actively prioritising investment driven revenue over asset prices. However with the economy moving further away from the previous crisis, the greater the building sense of optimism. Furthermore, exogenous social and political changes in reaction to whatever the previous crisis was can help intensify the atmosphere of positivity, for example: market liberalisation reforms, technological advancements, an end of war or, the discovery of new resources. Thus in this environment borrowers become more willing to explore external financing opportunities that carry interest and lenders become more willing to reduce the cost of credit. This mirrored optimism is key, as it helps explains why the supply of credit begins to expands. The ongoing recovery then compounds the optimism, because actors believe the prospect of economic recuperation increases the likelihood of successful investment and reduces the associated risk of loans. Stage 3 of the diagram coincides with the peak gains of the economic recovery. Investments delayed during the previous crisis are finally re-engaged during this period to take advantage of the economic recovery. The supply of credit in the economy continues to expand as borrowers begin to exceed their available retained earnings and demand more external loans. Lenders are increasingly willing to co-operate as they witness the wider economic recovery augmenting ever greater returns on investments funded through borrowed funds. Thus, the price of credit continues to decrease and total supply expands.
At the beginning of Stage 4 of the diagram, the returns from credit-funded investment continue to exceed credit costs (interest repayments). After a time however, the proportion of borrower’s operations being funded through borrowed funds grows and the availability of retained earnings decreases, meaning firms become increasingly reliant on the availability of credit to fund their businesses. Although, as the price of credit continues to fall because of the positive economic atmosphere and the bumper returns on investments because of the economic recovery, this does not hamper the ability of firms to carry on increasing the ratio of borrowed money on their balance sheets. As credit reaches its cheapest rates (lowest interest repayment rates), speculators begin to enter the market. Money is so cheap that these speculators are able to borrow heavily and provide very little capital as principal. These speculators use the cheap money to buy assets, causing prices to rise. By their nature, unlike the borrowers previously discussed, these actors are not earning money through profits generated by investment expanding output. Rather, these speculators earn their money by holding their leveraged assets until prices increase and then selling, profiting via the markup. Thus they are not offering any wider productive gains from their ownership of the assets, and it is by their own activities that prices are increasing. Furthermore, the success of such speculative activity during this period reinforces the attractiveness of speculation, drawing more and more speculators in and compounding the effects. With time, non-speculative borrowing begins to become comparatively less profitable because of investment’s necessary time-delays and inherent risks. Thus speculative activity, with its self-reinforcing profit persona, dominates the supply of credit in the economy.
With increasing indebtedness throughout the economy and the speculator dominance of the supply of credit, interest rates begin to rise – causing the supply of credit to taper off as we move from Stage 4 of the diagram to Stage 5. Interest rates are rising because they are positively correlated with debt-to-equity ratios. The greater the proportion of debt-to-capital in the economy, the greater the interest rates charged to cover risk. The higher interest rates begin to put pressure on debtors because they are forced to provide larger repayments. As speculators are not receiving any income from productive investments, they are making interest repayments out of pocket. Thus there comes a point where speculators are no longer able, or willing, to keep up with interest repayments. They have three main options: attempt to borrow more (assuming they have still have access and any available collateral, sell their leveraged assets at a loss (because the premature sale price will not cover their purchase price plus repayment spending) or default on their loans. Whichever the option, the trickling failure of more and more speculators causes asset prices fall and eventually collapse – because the premature/mass return of their assets floods markets. At an aggregate level, the underpinning principles of this class of market participant have been eradicated: they were totally reliant on asset prices continuing to rise. Furthermore, as speculators have crowded-out other types of borrowers, there is no productive expansion in the economy to help cushion the fall or profitably purchase the assets. Thus the economy lurches into recession – and credit availability, actor mentality and asset prices in Stage 5/6 mirror the situation in Stage 1 – previously discussed.
Thus the circular nature of economic crises repeats as we move from Stage 6 to Stage 7. However, as always, “this time is different”…
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