Minsky Moments

An American economist, Hyman Minsky, developed a set of theories that he felt explained behavior in speculative markets. Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles endogenous to financial markets. In broad strokes, price and market stability (e.g., good times) lead to excessive risk taking via debt issuance, and that stability then leads to instability as recency bias of good times continuing on forever takes hold of the investing public.  In other words, the system is designed to swing from boom to bust and back again, oscillating between robustness (stability) and fragility (instability), and that in fact is a feature of the business cycle.

Minsky stated that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.

This slow movement of the financial system from stability to fragility, followed by crisis, is something for which Hyman Minsky is best known.  And the phrase "Minsky moment" refers to this aspect of Minsky's academic work, around that tipping point from stability to instability.

This theory is centered on debt as the key mechanism for driving an economy towards a crisis.  Specifically, there are three types of borrowers in a 3-phase debt system that ultimately leads to an economic collapse of financial markets.  Here is a more detailed breakdown of the three phases that drive stability, which in turn drives speculative debt, ultimately leading to a price collapse born from forced liquidation when debt commitments cannot be met.

1) Hedge Phase: This phase occurs right after a financial crisis and after recovery, a time when banks and borrowers are overly cautious having losses fresh on their mind (e.g. recency bias). This causes loans to be small, ensuring that the borrower can afford to repay both the initial principal and the interest. Thus, the economy is most likely seeking equilibrium and virtually self-containing. This is the "not too hot not too cold" Goldilocks phase of debt accumulation; we are stable.

2) Speculative Phase: The Speculative period emerges as confidence in the banking system is slowly rekindled. This confidence brings about complacency that good market conditions will continue (e.g., recency bias, again). Rather than issue loans to borrowers that can pay both principal and interest, loans are issued where the borrower can only afford to pay the interest.  It is assumed at this initial stage in the debt cycle that the principal will be repaid by refinancing, which is the distinct mark beginning the decline towards instability.

3) Ponzi Phase: As confidence continues to grow in the banking system and banks continue to believe that asset prices will continue to rise, the third stage in the cycle, the Ponzi stage, begins. In this stage the borrower can neither afford to pay the principal nor the interest on the loans which are issued by banks.  This razor thin cash flow margin to cover only when appreciating value and force an immediate default when not met, is the distinct mark leading to foreclosures and vast debt failures. What is unique about the Minsky financial instability hypothesis is the use of interlocking balance sheets of the economy, which uncharacteristically included non-government entities or the private sector. 

In conclusion, I took away that good times with asset appreciation leads to excessive lending that in turn causes a crash.