The Financial Position of Dutch Households
A “Minskian” Perspective
Abstract:
After the financial crisis of 2007-‐2008, the global economy experienced a major recession. The Dutch economy was not spared, and especially the household sector was hit hard. This study analyses the developments in the Dutch household sector over the past 20 years, using a framework based on the Financial Instability Hypothesis (FIH). The FIH is a heterodox economic theory, which provides a coherent insight into the internal dynamics of the modern-‐day economy. Data on over 1,500 households over the past 20 years, obtained from the DNB Household survey, are used to analyse if the Dutch household sector overleveraged in the period prior to the recession, as the FIH predicted. The results suggest that this is not the case. Other possible causes of the crisis in the household sector, such as contagion from the financial sector, inadequate government policy and a decline in disposable income, seem more likely.
Master Thesis Date: 16-‐07-‐2014
Institution: University of Amsterdam Student: Lars Kroese
Student number: 6042554
Table of Contents Introduction ... 3 1. Theoretical framework ... 6
1.1. Interpretation of Keynes ... 6
1.2. Assumptions of the FIH ... 8
1.3. The dynamics of finance ... 12
1.4. The FIH; from a stable to an unstable system ... 15
1.5. Extensions of and contributions to the FIH ... 17
1.6. Similarities between the FIH and mainstream economics ... 20
1.7. Household finance ... 22
2. Methodology and data ... 26
2.1. Research, hypothesis and expected results ... 26
2.2. DNB household survey ... 27
2.3. Data and variables ... 29
2.4. Methodology ... 34
2.5. Overview of the variables ... 36
3. Results ... 37
3.1. Hedge, speculative, ponzi ... 37
3.1.1. Case I: 𝑋 = 0.2 𝑌 = 0.6 ℎℎ𝑖𝑛𝑐 > 𝑚𝑖𝑛𝑖𝑛𝑐 ... 38 3.1.2. Case II: 𝑋 = 0.25 𝑌 = 0.65 ℎℎ𝑖𝑛𝑐 > 𝑚𝑖𝑛𝑖𝑛𝑐 ... 41 3.1.3. Case III: 𝑋 = 0.3 𝑌 = 0.7 ℎℎ𝑖𝑛𝑐 > 𝑚𝑖𝑛𝑖𝑛𝑐 ...…...…... 43 3.1.4. Case IV: 𝑋 = 0.25 𝑌 = 0.65 ℎℎ𝑖𝑛𝑐 > 0 …... 44 3.2. Additional analysis ... 46 3.3. Interest payments ... 46 3.4. Mortgage debt ... 48 3.5. Household income ... 49 4. Discussion ... 50 5. Conclusion ... 61 References ... 65 Appendix I ... 69 Appendix II ... 70 Appendix III ... 82 Appendix IV ... 83 Appendix V ... 84 Appendix VI ... 85
Introduction
In late 2007, a global financial crisis erupted, triggered by a collapse of the value of assets and securities due to a crisis in the American subprime mortgage market. As a result several major global financial institutions failed, stock markets worldwide crashed and governments had to bailout systemically important banks. The housing market was also affected heavily, at first only in the USA, where house prices plummeted and many households were no longer able to service their mortgage, resulting in foreclosures. Soon the crisis spread, Europe was affected by the sovereign debt crisis and the whole (western) world was affected by a global economic recession. The Dutch economy was not
spared; Dutch banks required government support, house prices and sales collapsed and GDP growth stagnated, and even became negative in 2009, 2012 and 2013 (CBS, 2014). Especially the housing market was hit hard, house prices declined by approximately 20% in the period 2008-‐2013 and the number of houses sold declined from about 210,000 in 2006 to only about 110,000 in 2013 (CBS, 2014). At the same time as the value of the assets of households declined, the disposable income of households dropped due to the recession.
The developments in the Dutch economy, and particular the Dutch household sector, are interesting to analyse, as there are not many academic studies into the events and causes of the crisis in the Dutch household sector. What makes the Dutch housing market and household sector even more interesting, is that Dutch households have a notoriously high mortgage debt (Mattich, 2013), which is compensated by high pension savings, but these are not available to be withdrawn at request and can thus not be used for debt relief. These high debts might suggest that Dutch households have been overleveraged prior to the crisis, and that this high ratio of debts compared to income available to fulfil the payment obligations due to debt, might be a cause of the crisis in the Dutch household sector.
Mainstream economic theories do not suffice in providing an appropriate explanation for the crisis. They don’t account for several important concepts in our modern economy that cannot be neglected when analysing the economic crisis. One obvious aspect the mainstream economic theories mostly ignore, is the importance of finance and the interrelatedness of finance with the real
economy, which cannot be neglected after the immense impact of the 2007 financial crisis on the global economy. Another important conception that is not accounted for in most mainstream economic theories is fundamental
uncertainty. The economy is a complex system with many interconnections and unknowns, and not all possible outcomes can be predicted using a model and a probability distribution; some results are fundamentally incalculable.
Furthermore the large fluctuations observed in the business cycle of our modern economy are hardly compatible with the mainstream general equilibrium view, which is the view that the economy is a fundamentally stable system, only subject to (minor) random shocks.
A theory that does take into account the concepts mentioned above, and many more ideas that are missing in mainstream theories, is the Financial Instability Hypothesis (FIH) by Hyman Minsky (1919-‐1996), an American post Keynesian economist. He developed a coherent economic theory that is able to explain instability and show how it is generated. Minsky (1982b) regards instability as an important recurring characteristic of the modern economy. This study investigates if the FIH is an appropriate theory to explain the developments in the Dutch business cycle and in particular the Dutch household sector. The research question is formulated as follows: Can the Financial
Instability Hypothesis explain the developments in the Dutch economy, in particular the Dutch household sector, over the past 20 years? This question is answered in the discussion section after a careful analysis of data on Dutch households over the past 20 years, which are obtained from the DNB Household survey (CentERdata, 2014b.).
The paper is structured as follows: the first section describes the
theoretical framework, in which an outline of the FIH is given. The FIH is built-‐up from scratch, starting at Keynes (1936) and working towards the coherent theory of Minsky (1992) and further complemented with extentions by other authors. Furthermore the similarities between certain other economic theories and the FIH are discussed. At the end of the theoretical framework an overview of the relevant literature regarding household finance is given. The second chapter of this paper discusses the methodology of the research and the data used, including a section with the hypothesis and the expected results. The DNB
Household survey is also covered in this chapter. Furthermore a table with an overview of all variables that are used in the analysis is included. The third chapter consists of two parts: the main analysis and an analysis with additional evidence that does not directly follow from the narrative of the FIH. The fourth chapter is a discussion of the results. The last chapter is a conclusion, in which the whole paper is briefly summarized and the research question is answered. At the end of this paper the reference list and the appendices can be found.
1. Theoretical framework
This chapter contains an outline of the Financial Instability Hypothesis as originally developed by Hyman Minsky and summarizes the main concepts and underlying assumptions. Furthermore the developments in the relevant
literature on the FIH and related subjects are described and a brief overview of the literature on household finance is given.
1.1 Interpretation of Keynes
Hyman Minsky regarded his Financial Instability Hypothesis as an interpretation of the theories of John Maynard Keynes, which were laid out in “The General Theory” (1936). Furthermore Minsky builds upon the views of Joseph Schumpeter (1934) regarding money and finance and Charles Kindleberger (1978) and Martin Wolfson (1986) regarding disequilibrating processes and financial instability. Minsky also uses the concept of debt deflation as described by Irving Fisher (1933).
It is important to know that since the FIH is an interpretation of the original ideas of Keynes, it is fundamentally different from the dominant post-‐ WWII economic theories. The neoclassical synthesis, monetarism, new
Keynesian economics and new classical economics can be seen as the dominant schools of thought after WWII. All these schools can be captured under the common denominator that is neoclassical economics. For convenience I will, from now on, refer to these dominant schools as neoclassical or mainstream economics. Economic schools of thought that are not considered part of the mainstream are commonly referred to as heterodox economics, a term that I will also use when referring to the non-‐dominant economic schools of thought.
In 1975, John Maynard Keynes, a book by Minsky was published. In this book Minsky argues that the common interpretation of Keynes’ magnum opus, The General Theory (1936), was incorrect. The common interpretation in mainstream economics was an interpretation that regarded the theories of Keynes as an extension, or at most an evolution, of the neoclassical ideas of the time. The dominant interpretation of The General Theory (1936) is what Minsky (1977, p.20) calls “the Hicks-‐Hansen formulation of Keynesian theory and the
neoclassical synthesis.” John Hicks published the article Mr. Keynes and the Classics, A Suggested Interpretation (1937) in which he presents, for the first time, the famous IS-‐LM model. The model was extended and popularized by Alvin Hansen (1941). The neoclassical interpretation of Keynes is known as the neoclassical synthesis. Paul Samuelson (1948) was one of the first who
incorporated the neoclassical synthesis theories in an economics textbook. The book later became one of the all-‐time bestselling economics textbooks. Other important contributions to the neoclassical interpretation of Keynes were made by (later) famous economists as, Franco Modigliani, James Tobin, Robert Solow and many more. The neoclassical interpretation of Keynes was basically an incorporation of some of Keynes’ ideas into neoclassical economics. Minsky (1977, p.20-‐21) argues that this interpretation is not correct, as Keynes presented ideas in The General Theory (1936) that should be considered as a revolution rather than an evolution of the existing neoclassical school of thought. Minsky (1977) points out that Keynes himself did not agree with the
interpretation of his work in the spirit of traditional mainstream economics. In a rebuttal (Keynes, 1937) to professor Jacob Viner of the University of Chicago, Keynes disagrees that his General Theory (1936) does not make a sharp break with the, at that time, dominant economic school of thought. Minsky (1977) notes that the interpretation following from the rebuttal to Viner (Keynes, 1937) is not consistent with the interpretation suggested by Hicks (1937) and
subsequent mainstream interpretations. Minsky (1977, p.20-‐21) continues:
“Furthermore the interpretation of the General Theory that is consistent with Keynes’ rebuttal to Viner leads to a theory of the capitalist economic process that is more relevant and useful for understanding our economy than the standard neoclassical theory: this theory, which builds upon an interpretation of Keynes, is the “financial instability hypothesis.”
The starting point of the analysis of Keynes and Minsky on one side, and neoclassical economists on the other side, is the crucial difference from which almost all differences in assumptions, methods, results, etc. can be explained. Neoclassical economists use a simple barter-‐based market economy as
the starting point of their economic models and theories. Minsky (1977) calls this the “village fair paradigm”. It starts with the most simple basic form of an economy, where rational agents trade on a decentralized market, leading to cohesive and consistent results, which in some occasions are efficient. Most conclusions however only hold when strong assumptions are made (Minsky, 1982a). The theories based on this can be extended with contingent concepts and/or processes such as a production process, capital and investment, money and much more, but the basic assumptions and subsequently most of the results remain the same. Accordingly, neoclassical theory is unable to explain some anomalies as the periodical occurrence of busts and booms. Minsky (1982a) considers it important that a coherent economic theory is able to explain instability and show how it is generated, as it is an ever-‐recurring observed characteristic of the modern economy.
Keynes, and Minsky follows him in this, takes another point of view, a point of view that Minsky (1977, p.21) calls the “city or Wall Street paradigm.” The economy is viewed as a complex monetary economy with an ever-‐evolving system of financial interconnections between agents, firms and institutions. Minsky (1977) calls this the “city or Wall Street view” because this is how bankers, investors and managers from their skyscrapers in financial districts look at the economy. In this view finance is important and money is not just a tool used to smoothen the exchange of goods and services. The Keynesian “Wall Street paradigm”, which sees our modern economy as a “money manager capitalist economy” (Wray, 2011), where finance and money play a crucial role, is the starting point of the construction of Minsky’s financial instability
hypothesis (1977, 1992).
1.2 Assumptions of the FIH
As noted earlier, Minsky himself considered the FIH an interpretation and continuation of the ideas of Keynes, and thus many concepts used in the FIH directly follow from The General Theory (Keynes, 1936). This section goes into more detail regarding the concepts that Minsky borrows from Keynes (1936) to construct his FIH and explain the assumptions underlying the FIH.
One of the crucial deviations from the mainstream economic theory Minsky makes, is his view on money. Neoclassical theories consider money as exogenous, at least in the long run. If money is exogenous, it plays no role in the economy in the sense that it has no effect on real economic variables. Minsky thought money could not be neutral, neither in the long or short run, in these times where complex and expensive capital assets are commonly traded and are an important part of the economy. (Tymoigne and Wray, 2008). Keynes (1936) considered money as an endogenous variable in the economy, a special type of bond, the most liquid type of asset. The demand for money is determined by the liquidity preference of agents, a concept Keynes introduced in his General Theory (1936), which is a subjective value given to holding liquidity. If the value agents assign to holding liquidity increases, money demand will increase, while the demand for less liquid assets, such as machines and long-‐term bonds, will go down. Furthermore money connects the owners of assets, the producers, with the owners of wealth, the investors. In the modern economy producers often need to borrow money to acquire capital, and they do this through banks, or other financial institutions. Owners of wealth on the other hand seek a way to get return on their money. Via the financial sector they lend out their money to the producers. These investors have claims on money, not on real assets, and thus money is the connection between the investors and the producers. Keynes calls money a “veil between the real assets and the wealth owner” (Minsky, 1977). This veil is the connection between money and the financing process taking place in the economy through time. Time is important in this respect, as the process is dynamic. Financial contracts entered at one point in time lead to payment obligations in the future. This is another important difference with neoclassical theory, which mostly abstracts from time (Minsky, 1982a).
Furthermore, Keynes (1936, 1937), and Minsky (1977) agrees with him, thought that there are always disequilibrating forces affecting the economy. The view of Keynes (1936, p.108) and Minsky was that the economy is fundamentally unstable, which contrasts with the mainstream Walrasian general equilibrium view that the economy is fundamentally stable and it is occasionally hit by disequilibrating shocks, after which the economy automatically returns to equilibrium. This is more or less the opposite of Minsky’s point of view. Minsky
(1992) argues that over prolonged periods of prosperity, the economy departs from stability and inevitably becomes unstable. Thus, the perceived stability associated with a prolonged period of economic growth actually conceals the development of the economy becoming increasingly unstable. This is essence of Minsky’s FIH and can be captured in the famous statement: “stability is
destabilizing”.
Especially the investment decision process is subject to these
disequilibrating forces. According to Minsky (1977), the investment decision plays an essential role in the economy, as investments are the main determinant of the volatility of aggregate activity. Whether or not firms decide to invest, depends on the price of a capital asset relative to its output price and financial conditions (Minsky, 1977). Expected returns on a capital asset are composed of the asset’s expected yield, the carrying cost, liquidity and the expected price change. All assets have a different expected return, and a different composition of the expected return. Some assets provide more return in the form of liquidity (e.g. money), while others have high-‐expected yields (e.g. machines). The
demand for liquidity is determined by the liquidity preference of agents. As expectations change, so do the liquidity preference of agents and the expected yields of capital assets. The result is that the expected return on capital assets changes, but the change is not equal for all assets, the relative return on one asset compared to others also changes. It is clear, that in this process, expectations about the future are essential in determining the level of investments and thus output and employment (Tymoigne and Wray, 2008). Expectations are however not determined by rational agents with selfish motives, who make no systematic errors in predicting the future, as in
neoclassical theory, but in an expectation formation process where people have to deal with the absence of information and fundamental uncertainty.
Keynes (1936) distinguished two shorts of “uncertainty”. The first is the concept of risk, similar to the mainstream conception of risk. It can be calculated as it has a probability distribution, an expected value and mean, standard
deviation, etc. In combination with rational expectations and perfect information this will enable agents to make perfectly rational decisions. The second type of “uncertainty” Keynes distinguished is fundamental uncertainty, which is
unknown and cannot be calculated, similar to Knightian uncertainty (Knight, 1921). This uncertainty is not taken into account in neoclassical models since it is by definition impossible to formalize or model fundamental uncertainty. Keynes however was convinced this concept of fundamental uncertainty was important and he was critical about theories that only took calculable risk into account since they did not capture the real world situation. As Keynes explained:
“human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist;” (Keynes, 1936; p.162-‐ 163).
In a world with Knightian uncertainty, agents are not able to calculate outcomes regarding the future with certain probabilities and thus cannot fully know the consequences of actions beforehand. So even if agents would be rational, it would not help people to reach optimal outcomes.
Keynes, Minsky and in fact many heterodox economists, however reject the concept of rational agents. Keynes (1936) thought people tried to reduce the fundamental uncertainty by forming a vision about the future through social interactions. In this social process the average opinion about the appropriate prices is determined. This has two main implications; first, a self-‐fulfilling process will start in which the socially created expectations will tend towards the existing prices. Secondly, the social conventions created will lead people to behave in a manner such that the expectations come true (Tymoigne and Wray, 2008).
The General Theory (Keynes, 1936) connects some important concepts, forming the basis of a business cycle theory. A business bases its decision whether to invest or not, on the expected return on capital assets. The expected return on capital assets is influenced by subjective expectations about the future, which are determined in a social process. Furthermore, investments are the main determinant of the volatility of aggregate activity. This implies that there is a causal relation between expectations and aggregate activity. Since expectations are subjective and confidence about the future plays a major role in the process
that establishes these subjective expectations, it is possible for self-‐fulfilling speculative booms to develop during periods of economic prosperity.
1.3 The dynamics of finance
The crucial observation Minsky (1982b) makes, and which forms the focus of the FIH, is that the “structure of finance” matters a lot. The finance structure of firms, households and governments, more specifically their liability structure, commits the future cash flows of these agents and institutions. Minsky (1982a) notes that cash flows always have three functions. The first function is to signal the quality of past investment decisions. The second function is providing funds to meet payment commitments. And the last function of cash flows is determining the conditions for present and future investment and the possibilities to finance investment (Minsky, 1982a, p.9). Thus, cash flows play an important role in the investment decision process. Keynes (1936) already observed that (subjective) expectations are an important determinant of investments. Minsky (1982a) adds to this that investments are determined by borrowing, lending and interest rates. Financial commitments also enter the investment decision process, as past financial arrangements have an influence on the prices of capital and financial assets, and new financial arrangements are needed to finance present and future investment. Furthermore investment is an important and volatile component of aggregate demand and thus a determinant of employment, output and profits. To summarize Minsky (1982a): both cash flows from operations and payment commitments due to the structure of the financing of liabilities determine investments, which in turn determine economic activity and the course of the economy. The process described is a dynamic process; over time both cash flows and the structure of finance change and evolve. As Minsky (1992, p.4) puts it:
“In a capitalist economy the past, the present, and the future are linked not only by capital assets and labour force characteristics but also by financial relations”
As noted earlier, money is the link between all the components in the investment decision process; it connects investors with producers, the past with the present and cash flows with payment commitments. Key in this process is the financial system. Financial institutions, which are just as other businesses profit-‐seeking firms, channel money flows and create financial contracts, which constitute the future payment commitments of households and businesses. The financial system can be(come) institutionally complex, with several layers of
intermediation and various interconnections between financial institutions, resulting in a large distance between the agents who are the owners of wealth and the agents who are the operators of wealth. Our current financial system is arguably a good example of how complex and extensive a financial system can become. In the financial system, the flow and market price of finance are determined by expectations of business profits and returns (Minsky, 1992). Current cash flows and profits determine whether it is possible for businesses to fulfil the payment commitments due to debt. Current profits and cash flows in turn are dependent upon past investments, while future profits and cash flows, or the expectations thereof are dependent on current investment (Minsky,
1992). Therefore, the ability of businesses to fulfil their payment commitments is dependent on past investment and the ability to engage in new financial
contracts is dependent on current investment, which is dependent on past
investment. This process continues over time and forms a recurring cycle. Figure 1 shows a schematic representation of the connections between profit and cash flow, investment, and the ability to meet and engage in new financial
commitments, as they influence each other over time.
Investment
Cash jlow and projit
Ability to meet jinancial commitments Ablity to engage
in new jinancial commitments
Figure 1. Schematic representation of the relation between interest, cash flow and profit and financial commitments
It is evident, as explained above, that finance, and in particular debt and the structure of debt plays a crucial role in the FIH. Minsky (1992) calls the FIH a “theory of the impact of debt on system behaviour.”
The FIH revolves around the three “ways” of financing, or income-‐debt relations as Minsky calls them. Minsky thought that the analysis of how
investment is financed was missing in the work of Keynes, as Keynes seemed to assume that funds for the financing of investment are simply always available (Tymoigne and Wray, 2008). Minsky (1992), however thought the way a firm or household finances it’s investments is crucial. He distinguishes three sorts of finance profiles:
1. Hedge finance: the cash flow from operations of a hedge-‐financed
economic unit is larger than all payment commitments due to debt of that economic unit at a particular date.
2. Speculative finance: a speculative-‐financed economic unit can meet its interest payment commitments due to debt, but is not able to meet all principle-‐payment commitments due to debt out of its cash flows from operations at a certain point in time. Hence it needs to “roll over” debt.
3. Ponzi finance: a ponzi-‐financed economic unit cannot meet any payment commitment due to debt from its cash flows from operations at a
particular date. Ponzi units can only sustain in an environment of rising asset prices. Its needs to refinance principle payments as well as interest payments by issuing new debt, or by selling assets.
1.4 The FIH; from a stable to an unstable system
The first Theorem of the FIH states that there are financing systems for which the economy is stable and financing systems for which the economy is unstable. The second theorem of the FIH states that during periods of economic growth the economy evolves from a system with stable financial relations to a system with unstable relations (Minsky, 1992, p.8). The shares of the different
categories of finance in the economy determine the stability of the economy. Minsky (1992) observed that over prolonged periods of economic growth, the system of finance in the economy as a whole tends to shift from dominated by hedge-‐financed units to speculative financed and even ponzi-‐financed units. As one can probably imagine, an economy is less stable if the share of speculative and especially ponzi units is large compared to the share of hedge-‐financed units. Minsky (1982b) emphasized that hedge-‐financed units have a “cushion of
safety”, to absorb financial setbacks, namely their equity. Speculative and ponzi units do not have these “cushions” and the risk of bankruptcy for those units is much greater when confronted with economic crises, (financial) misfortune, etc. Especially ponzi-‐financed units are continuously on the brink of the abyss, as they are totally dependent on refinancing for their payment commitments. Minsky (1992) explains that in the particular situation where an economy that contains a sizeable share of speculative-‐financed units and is experiencing inflation, which the monetary authorities try to mitigate by constraining money growth or other contractionary monetary policies, then speculative-‐financed units will become ponzi-‐financed units easily and units who were previously ponzi will have a large chance of going bankrupt. This process works via rising interest rates, either because of tighter monetary policy by the central bank, or via increased demand for loans, or through any other channel that can influence the interest rate. The increased interest rate raises the cost of the production of
investment output, since production is frequently financed by (short-‐term) debt, and it will also create a downward pressure on the value of capital assets
(Minsky, 1982a). As a result, investments decrease. Decreasing investments have a deteriorating effect on the expectations of future profits. The result will be that the economic outlook will be less bright. Because of the declining economic situation, financial institutions will be less inclined to provide finance for new projects or refinancing of debt to businesses. Moreover the finance still provided will be more expensive and the conditions for receiving loans will be more stringent. For hedge-‐financed businesses and households this will result in more financing costs, less investments and less equity, and there will be a chance that hedge-‐financed units will become speculative-‐financed. For speculative and ponzi financed units however, it will have more drastic implications. For
speculative units it will mean that the refinancing, which is necessary to meet the principle-‐payment commitments, is getting more and more expensive, creating the possibility that such a unit will become a ponzi-‐financed unit. For ponzi units the deteriorating economic outlook is destructive. They will not be able to
refinance maturing debt and they will not be able to meet payment
commitments. Ponzi units will be forced to sell assets to compensate for the shortfall of cash flow. The paradox is however that, when a large enough share of the businesses and/or households will be in trouble and will be forced to sell assets, asset prices will plunge, leading to a collapse in asset values (Minsky, 1992). This will have devastating effects for the economy as a whole, triggering a debt-‐deflation process a la Irving Fisher (Minsky, 1977). The result of higher interest rates is that, via decreasing asset prices, rising cost of holding assets and decreasing profits, the solvency and liquidity of businesses and households and the stability of the financial system and the economy is jeopardized (Minsky, 1982b). Therefore, the investment decision, influenced by several factors that were outlined earlier, affects the profitability, solvency and liquidity of all economic units in the system. The logical conclusion of the FIH is that the internal dynamics of capitalist economies and interventions and regulations by the monetary authorities are the drivers of the business cycle (Minsky, 1992). The business cycle consists of six stages according to Minsky (1982b). The first stage is one of accelerating inflation, caused by a booming economy. The
second stage is a financial crisis. This crisis is caused by the dynamics of finance as explained earlier. A significant blow to the real economy characterizes the third stage. At this point the financial crisis developes into a full-‐blown economic crisis via a debt-‐deflation process. The fourth stage is reached when the
government or monetary authorities intervene in the economy, trying to counter the recession by monetary and fiscal stimulation. This intervention causes a breaking of the downturn of the economy, which is the fifth stage. Finally the sixth state is one of renewed expansion, fuelled by bright prospects and positive expectations about the future.
1.5 Extensions of and contributions to the FIH
The FIH is an intuitive and comprehensive but coherent theory of how the internal dynamics in a capitalist system, characterized by extensive and complex financial relations, can cause business cycles of booms and busts. Although Minsky was clear about the structure of his theory and the elements it should contain, he did not elaborate on how to model it mathematically, neither was he explicit on the sizes of the shares of speculative or ponzi units an economy must contain to become unstable. Although Minsky himself was a skilled
mathematician, he thought it was more appropriate to use a narrative approach rather than a formal approach when doing economics. However, economists influenced by the work of Minsky not only maintained his legacy and continued research on and in the tradition of the FIH, but also made the first steps
regarding the formalization and modelling of the FIH. Subsequent work, by economists who built upon Minsky’s ideas, staying in the (post) Keynesian tradition, was done in several areas. The most important contributions to the literature related to the FIH are summarized in this section.
The first area where authors, inspired by the FIH, have done a lot of work is the original interpretation and extension of the narrative theories of Minsky. Authors like Tymoigne and Wray (2008), elaborated on the interpretation of Keynes and Minsky and extended the FIH with a more sophisticated analysis of asset pricing and the evolution of the financial system. They emphasize that asset prices in the theories of Keynes and Minsky are not based on the theories of rational or adaptive expectations, but more on a Keynesian theory of
“conventional expectations.” People are ignorant and their expectations are not based on fundamentals of the economy, not because they are not able to think rationally but rather because the future is fundamentally unknown (Tymoigne and Wray, 2008). The implication is that there is room for several self-‐fulfilling processes to occur. Asset prices might be considered as the right price, because the socially accepted value converts to whatever this price will be. People might behave in a way that will confirm their expectations about the future. If
expectations are not controlled and/or managed by for example, regulations or (government) institutions, speculative bubbles can develop due to this process. Another author who developed the narrative approach of Minsky is for example Kregel who uses the FIH to examine the events during the subprime mortgage crisis in the USA (Kregel, 2008). Whalen did something similar, also applying Minsky to the recent credit crunch (Whalen, 2009). Another analysis of the recent financial and economic crisis is by Wray (2011). He notes that the crisis was inevitable as just as Minsky pointed out, endogenous processes
pushed the economy towards being a fragile unstable system, and sooner or later the bubble had to burst. Wray (2011) concludes with the statement that the impact of fundamental uncertainty on the economy needs to be reduced by creating new economic institutions that will constrain this uncertainty. A pioneer in modelling and formalizing the FIH is Steven Keen. Keen is one of the few economists concerned with creating consistent models, which both capture the real economic events and are based upon the theories of
Keynes, Minsky and other (post) Keynesian economists. The starting point of his models is post Keynesian theory rather than neoclassical theory. The models Keen (1995, 2011) created could be categorized as complexity models, showing similarities with complex models in other fields of science. Keen thinks that non-‐ linear complexity models are much more appropriate to capture the essential features of the economy than neoclassical stochastic models (Keen, 1995). Ryoo is another economist who is concerned with modelling Minsky’s and other (post) Keynesian theories in a more formal way. In his paper Ryoo (2013) uses a
Minsky-‐Harrod approach. The “Harrodian” element is in the accumulation behaviour of firms. Firms desire to accumulate capital at a certain rate, in the short run however, this desired rate of accumulation (utilisation) is not always
met, because the capital stock adjusts slowly and actual demand is not always equal to expected demand (Ryoo, 2013). The result is that the actual rate of utilisation fluctuates around the desired rate. Ryoo (2013) combines the FIH of Minsky with the accumulation concept of Harrod. In his model, Minsky’s theories provide the basis for the long run cycle, while Harrod’s theory explains the short run fluctuations. The model he constructs is a stock-‐flow consistent model, a special type of model that is incompatible with mainstream economics. Ryoo (2013) uses his model to discuss the implications of Minsky’s ideas about how to stabilize the economy. Ryoo (2013) finds that a rise in the debt ratio of firms, which he defines as debt divided by capital, leads towards a self-‐reinforcing dynamic. Key mechanisms in this dynamic system are bank leverage and the profit-‐seeking behaviour of banks. Eventually unsustainable expansion of credit will lead to a financial contraction (Ryoo, 2013). Chiarella and Di Guilmi (2011) constructed a model that tries to capture the elements of the FIH. Their model is a micro-‐founded model, which is also common practice in the mainstream of economics, but lays special emphasis on financial variables and incorporates a lot of new elements. Examples of concepts used by Minsky in the FIH that are also used by Chiarella and Di Guilmi (2011) are endogenous money,
heterogeneous agents and firms and heterogeneous and complex financial conditions. They use the model to do computer simulations and provide some insights on financial fragility and possible stabilization policies. Chiarella and Di Guilmi (2011) find results similar to Minsky’s intuition presented in the FIH; in boom periods, firms take on more debt, eventually the units in the worst
condition regarding their financial position start to fail, the process is reversed, causing an economic slump. Chiarella and Di Guilmi (2011) recommend
stabilizing the economy by reducing the capacity to create endogenous money and regulating debt levels.
Another area where Minsky himself did not do much work is in empirical research. As noted earlier, Minsky used a narrative approach, which he used to explain events and elaborate on his view of the business cycle, but he did not do empirical research supported by economic data. Other economists however have done empirical research on the FIH. Mulligan (2013a) for example used data on over 8500 firms in North America to analyse how big the shares of hedge,
speculative and ponzi firms in the economy are, and furthermore analysed the development of these shares over time. In another study he also used empirical data on firms in North America to examine the similarities of the FIH and Austrian business cycle theory (Mulligan, 2013b). Tymoigne (2011) tried to capture the “ponziness” of the economy by creating a fragility index consisting of several indicators that could signal the share of ponzi-‐financed units in an
economy. His conclusion is that indeed the share of ponzi-‐financed units was increasing in the economy prior to the recent financial crash. However, the share of ponzi units was already large from the beginning. Furthermore he also
observes that there is no convincing evidence of a real debt-‐deflation process, which could indicate that there is no such a cycle as Minsky (1992) suggested. Tymoigne (2011) is however sceptic about his own results, as he acknowledges that a fragility index might not be able to capture the process described in the FIH.
1.6 Similarities between the FIH and mainstream economics
Apart from several authors who interpreted and extended the FIH in the
“Keynes-‐Minsky” tradition, predominantly post Keynesian economists, there are also economists from other traditions, mainstream and heterodox economics, who developed and worked on theories that show remarkable parallels with the FIH. Maybe most remarkable are the similarities of the FIH with Austrian
business cycle theory (ABCT). Although not considered mainstream economics, Austrian economics did have a great influence on a lot of mainstream
economists. Probably the most famous Austrian economist, and also one of the founders of the Austrian tradition, is Nobel Prize winner Friedrich von Hayek. He was in Keynes’ time one of the main opponents of Keynes’ theories, which makes the similarities between the FIH and ABCT all the more interesting. The
resemblances between the FIH and ABCT mostly lay in the emphasis on credit, capital, investments and debt in the economic system. Both in the ABCT and the FIH credit and credit growth in particular are the drivers of the business cycle. There is a similar dynamic of credit growth leading to asset price bubbles. In ABCT bubbles are caused by malinvestments rather than because of the speculative nature of financing during an economic boom as in the FIH is the
case. In both theories an unsustainable build-‐up of debt will eventually lead to a bust and a credit crunch. An important difference is however that ABCT stresses that this is the result of (bad) monetary policy, an exogenous process, while the FIH sees this as a result of endogenous dynamics in the financial system
(Mulligan, 2013b). Furthermore debt commitments are an important concept in both theories. Mulligan (2013b) compares real business cycle theory (RBCT), Austrian business cycle theory and the financial instability hypothesis and concludes that ABCT and FIH are to a certain extent complementary theories, while the mainstream RBCT is a competing theory and is not compatible with either the FIH or ABCT.
Another theory that seems to be remarkably similar to the FIH is the theory on leverage cycles. Leverage is a measure of the amount of debt compared to the amount of equity of an economic unit. If debt is high compared to equity, a unit uses a lot of external finance; the leverage (ratio) is high. If debt is low compared to equity, the unit’s main source of finance is internal; the leverage (ratio) is low. Leverage cycle theory revolves around the observation that leverage ratios fluctuate and seem to move together with or even cause business cycles (Geanakoplos, 2010). Fostel and Geanakoplos (2008) present one of the first mainstream economic theories in which finance matters, and in that respect already connects with the FIH. Leverage cycles are caused by a process that is similar to the financial cycle Minsky (1992) described. Geanakoplos (2010) explains that some buyers might be willing to pay more for certain assets than other people. This can be due to various reasons, these people can for example have a more positive view of the future, or they can be less risk averse or the product is just more preferred by some. These people are willing to pay more, and if they have access to credit, are willing to take on more leverage to finance the purchase of the product. This drives up the price of the asset and can give rise to asset price bubbles. Geanakoplos (2010) notes that, without interference, leverage becomes too high in good times and too low in bad times. This results in asset prices that also are too high in good times and too low in bad times. The most important conclusion is that financial variables have a huge impact on the economy. Geanakoplos (2010, p.6) recognizes the efforts of Minsky, who already stated that high leverage ratios were dangerous for the economy decades ago.
