Does Capitalism Itself Create Economic Instability or Is Central Banking the Culprit?
Instability in financial markets has brought back the ideas of post-Keynesian school of economics (PK) economist Hyman Minsky. Minsky held that the capitalist economy inherently is unstable, culminating in severe economic crisis, accumulation of debt being the key mechanism pushing the economy toward a crisis.
During “good” times, according to Minsky, businesses in profitable areas of the economy are well rewarded for raising their level of debt. The more one borrows the more profit one seems to be making. The rising profit attracts other entrepreneurs to join in and encourages them to raise their level of debt.
Since the economy is doing well, and borrowers financial health shows a visible improvement this makes lenders more eager to lend. Over time, however, the pace of debt accumulation starts to rise much faster than borrower’s ability to repay and serve the debt. At this stage, the foundation for an economic bust is set in motion.
Minsky distinguishes between three types of borrowers. The first type he labels hedge borrowers that can meet all debt payments from cash flows. The second type are speculative borrowers who can only meet interest payments but must constantly roll over their debt to be able to repay their original loans.
The third group of borrowers Minsky labels as Ponzi borrowers that cannot repay neither the interest nor the original loan. These borrowers rely on the appreciation of the value of their assets to refinance their debt.
This framework comprises what Minsky calls the financial instability hypothesis (FIH). According to the FIH, financial structure of a capitalist economy becomes more and more fragile during the period of prosperity. The longer the prosperity the more fragile the system becomes. According to Minsky:
In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.
Another aspect of the FIH is that during good times, banks and other intermediaries by means of sophisticated innovations try to lure investors to buy the debt. Minsky
Article from Mises Wire