The Financial Instability Hypothesis

The Financial Instability Hypothesis

by
Hyman P. Minsky* Working Paper No. 74

May 1992

*The Jerome Levy Economics Institute of Bard College Prepared for Handbook of Radical Political Economy, edited by Philip Arestis and Malcolm Sawyer, Edward Elgar: Aldershot, 1993.

The financial instability hypothesis has both empirical and theoretical aspects. The readily observed empiricalaspect is

that, from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes the economic system's reactions to

a movement of the economy amplify the movement--inflation feeds upon inflation and debt-deflation feeds upon debt-deflation. Government interventions aimed to contain the deterioration seem tohave been inept in some of the historical crises. These

historical episodes are evidence supporting the view that the economy does not always conform to the classic precepts of Smith and Walras: they implied that the economy can best be understood by assuming that it is constantly an equilibrium seeking and sustaining system. The classic description of a debt deflation was offered by IrvingFisher (1933) and that of a self-sustaining disequilibrating processes by Charles Kindleberger (1978). Martin Wolfson (1986) not only presents a compilation of data on the emergence of financial relations conducive to financial instability, but also examines various financial crisis theories of business cycles. As economic theory, the financial instability hypothesis is an interpretation of thesubstance of Keynes's "General Theory". This interpretation places the General Theory in history. General Theory was written in the early 193Os, the great financial and real contraction of the United States and the other
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As the

capitalist economies of that time was a part of the evidence the theory aimed to explain. The financial instability hypothesis

also draws upon the credit view ofmoney and finance by Joseph Schumpeter (1934, Ch.3) Key works for the financial instability

hypothesis in the narrow sense are, of course, Hyman P. Minsky (1975, 1986). The theoretical argument of the financial instability hypothesis starts from the characterization of the economy as a capitalist economy with expensive capital assets and a complex, sophisticated financial system. The economicproblem is

identified following Keynes as the "capital development of the economy," rather than the Knightian "allocation of given resources among alternative employments." The focus is on an

accumulating capitalist economy that moves through real calendar time. The capital development of a capitalist economy is accompanied by exchanges of present money for future money. The

present moneypays for resources that go into the production of investment output, whereas the future money is the "profits" which will accrue to the capital asset owning firms (as the capital assets are used in production). As a result of the

process by which investment is financed, the control over items in the capital stock by producing units is financed by liabilities--these are commitments to pay money atdates specified or as conditions arise. For each economic unit, the

liabilities on its balance sheet determine a time series of prior 2

payment commitments, even as the assets generate a time series of conjectured cash receipts. This structure was well stated by Keynes (1972) : There is a multitude of real assets in the world which constitutes our capital wealth - buildings, stocks ofcommodities, goods in the course of manufacture and of The nominal owners of these transport, and so forth. assets, however, have not infrequently borrowed money (Keynes' emphasis) in order to become possessed of them. To a corresponding extent the actual owners of wealth have A considerable claims, not on real assets, but on money. part of this financing takes place through the banking system, which...