Minsky's Financial Instability Hypothesis (Financial Economics)
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Last updated 21 Mar 2021
This is a short study note on Hyman Minsky's financial instability crisis.
Minsky argued that:
- Over periods of prolonged economic prosperity and high optimism about future prospects, financial institutions invest more in ever-riskier assets in search of higher returns, which can make the economic system more vulnerable in the case that default materialises.
- When bad economic news eventually happens, the financial system risks being too highly leveraged and is at risk of systemic collapse as asset prices start falling and real incomes and jobs contract.
Minsky argues that the financial system is inherently unstable
- Take an economy currently experiencing a phase of strong growth (“tranquil period”) but with debts from previous cycles
- Strong growth phase increases profits of the banks
- Rising incomes and employment makes debt more serviceable
- Lending criteria considered prudent in the past are relaxed
- Increase in supply of credit increases the leverage of the banking system
- Credit boom drives economic growth and asset prices
- Rising debt-to-GDP ratio increases the risks for an economy if there is an external shock
- Small increases in bad debts can make the system unstable