Misinterpreting Minsky

Let us consider an out-of-context excerpt from Dynamic Effects of Total Debt and GDP: A Time-Series Analysis of the United States, Patrizio Lainà's master's thesis.

Presenting the theoretical framework of his thesis, Lainà begins with the financial instability hypothesis of Minsky:

Minsky (1982 & 1986) presents the process of financial instability as follows:

1. The process starts from a situation where the real economy is healthy and growing. Firms and financial institutions are, nevertheless, cautious and try to avoid risky investments due to a crisis in the recent past.

2. However, low-risk investments keep on succeeding and economic growth accelerates. Positive development of balance sheets inspires the firms and investors to take more risk as it tends to be clearly profitable. More finance is needed and the banking sector loosens its lending terms. In this situation both debtors and creditors see a bright future.

3. A self-reinforcing cycle is born as new debt money increases the demand for financial assets, housing and other investments. Financial institutions loosen their lending terms more and, for that reason, hedge, speculative and Ponzi borrowers appear on the market. First, there appear the hedge borrowers. They can make debt repayments, covering interest and principal, from the cash flows the investment produces. After the hedge borrowers, speculative borrowers will appear. They can service the debt, that is, make interest payments, but they must regularly roll over the principal. Finally, the Ponzi borrowers will appear. They found their investment strategy on the assumption that asset values will keep on rising. Ponzi borrowers cannot make sufficient payments on interest or principal from the cash flows the investment provides, but they refinance the debt with the appreciated asset value.

My title -- Misinterpreting Minsky -- is not offered as a critique of Patrizio Lainà's summary. On the contrary, I quote Lainà's summary because is is a very clear presentation of the only interpretation ever offered of Minsky's financial instability hypothesis. To the world, it will be my interpretation that is the misinterpretation. To me it is not Patrizio Lainà who misinterprets Minsky, but the world.

Let me begin by summarizing Lainà's summary. He presents three steps:
1. the real economy is healthy and growing, which leads
2. firms and investors to take more risk, until finally
3. a self-reinforcing cycle is born.

These are not so much separate steps as phases of a gentle, continuous transition. The continuity is evident in Lainà's presentation even though he creates and numbers three separate paragraphs.

It is this clearness in Lainà's presentation that induced me to quote him.


Lainà's three numbered paragraphs describe one smooth, continuous transition. But consider now paragraph number three. I repeat it below in shortened form:

Financial institutions loosen their lending terms more and, for that reason, hedge, speculative and Ponzi borrowers appear on the market. First, there appear the hedge borrowers... After the hedge borrowers, speculative borrowers will appear... Finally, the Ponzi borrowers will appear.

See how cut and dry this is? First, second, third. One, two, three.

Within the third paragraph, Lainà describes three unique and independent steps in the rise of instability. In his presentation, the three numbered paragraphs present one continuous transition. But the last of those paragraphs presents three separate and distinct steps.

It is not only Lainà who presents Minsky in this manner; so also does the world. I think the presentation of independent steps is incorrect. As I said, one of us is misinterpreting Minsky -- perhaps me, perhaps the world. You know what I would say about that.


Let me go back and fetch from Paragraph 3 some things omitted from the shortened form. We have first

the hedge borrowers. They can make debt repayments, covering interest and principal, from the cash flows the investment produces.

Second, the speculative borrowers:

They can service the debt, that is, make interest payments, but they must regularly roll over the principal.

Third, the Ponzi borrowers:

Ponzi borrowers cannot make sufficient payments on interest or principal from the cash flows the investment provides

The first group or category can cover both interest and principal from the income generated by the investment. The second can cover interest, but not principal. The third can cover neither interest nor principal from the generated income. These are not groups. They are categories of distress. They are categories of financial distress originated by Minsky to describe the changes within a continuum.

Lainà and the world present hedge, speculative and Ponzi as separate groups, arising in chronological sequence. I see them as stages of distress in the development of financial instability. It is not important that we call one "hedge" and another "Ponzi". What is important is to see the deterioration of income that arises from the continued growth of finance.