Hyman Minsky was a little-known, little-read economist — until the financial crisis.

Minsky argued that the modern financial system is naturally unstable and, if left alone, would inevitably collapse.
He developed the Financial Instability Hypothesis to explain his reasoning. In the aftermath of an acute financial crisis (like the Great Depression, or the recent financial crisis), businesses and financial institutions are very conservative and operate on a low-risk basis — tight credit. During this time of low risk, businesses succeed, loans are paid on time and the economy booms. But this success slowly erodes the memory of the financial crisis, edging more and more risk into business practices and financial policies.

What eventually develops is a euphoric economy propped up by two kinds of borrowers:

  • Speculative borrowers, whose real incomes only cover interest payments but not payments of the principal; and
  • Ponzi borrowers, whose incomes can neither cover interest payments nor principal payments, and who must borrow further in order to make payments.

This type of economy is based on the free access of credit rather than successful business and financial practices. And while the economic tide continues to be high, the market appears to be business as usual. However, once the tide begins to ebb, everyone knows who was swimming naked.

This financial exhibitionism is brought on by a “Minsky Moment”. A panic (like the failure of a bank) sets off a wave of fear, compelling companies to dump their debt and sell assets. This lack of liquidity — access to money — creates an environment in which speculative and Ponzi borrowers are unable to survive, revealing the true nature of their business practices.

Even stable players may find themselves struggling, and be forced to sell off assets, forcing asset prices ever downward. Thus, the financial system itself begins to lurch and the crisis spills over into the rest of the economy, which depends on the now-failing financial system.

So what to do about Minsky Moments? Minsky suggested a twofold solution: the Big Bank and Big Government.

The Big Bank refers to the Federal Reserve. The Fed has an unlimited supply of money for lending. By providing funds, the Fed could break the downward cycle and allow borrowers to stay afloat, stabilizing the financial market.

Big Government refers to a job-providing government. Minsky argued that the government should employ anyone who wants a job at minimum wage in order to prop up the wages of skilled workers and pull people off of the unemployment line.

first tuesday take: Minksy explains American financial history since 1980.

And the Minsky Moment exemplifies exactly what happened leading up to the financial crisis. Our markets are made up of people, and people are emotional, irrational and instinctual. We drive our economy like we drive the freeways in afternoon traffic: stop, go, foot to the petal, then the brake. Go, then stop; wait, then rush. Add extreme risk taking to the mix and sometimes you end up with a 30-car pile-up: our animal instincts at work.

That is why regulation of the parameters which control businesses is so absolutely necessary. Cash is artificial — fiat money — and as such it must be controlled. Because accidents on the financial freeway can have devastating consequences for everyone else on the road.

Re: “Why capitalism fails,” from The Boston Globe.