Stability Is Destabilizing The Relevance To The 2008 Financial Crisis
A capitalistic economy follows the trends in the market. Due to the increasing cases of lending from banks, the risk of facing a financial crisis caused by the market instability becomes particularly high. The Minsky’s financial instability hypothesis is based on the supposition that economic stability encourages lenders and borrowers to be reckless in their financial activities. As a result, a financial bubble created in the market must bust sooner or later. As such, capitalism is characterized by a cyclic periods of stability and instability, which the government must address with regulations to minimize instability risks (Minsky 1996, p. 10). The aim of the current paper is to explain the statement “Stability is destabilizing” with reference to Minsky’s financial instability hypothesis relate it to the 2008 global financial crisis.
Minsky’s Financial Instability Hypothesis
The Minsky’s financial instability hypothesis states that economic boom is characterized by a cash flow which is not sufficient to pay off debts. In the process, there develops a speculative euphoria, which leads to the exceeding debts which the borrowers cannot afford to pay off from their earnings creating a financial crisis. The result is that banks and other financial institutions withdraw their credit even to the borrowers capable to pay back the loans; this process leads to the economy collapse. Concerning financial instability, Minsky observed that “Instability is determined by mechanisms within the system, not outside it; our economy is not unstable because it is shocked by oil, wars, or monetary surprises, but because of its nature” (Minsky 2008, p. 21).
The financial instability hypothesis is premised on three kinds of insolvent borrowers – hedge, speculative, and Ponzi borrowers. Each of them has a unique relationship to a particular economic unit. An economy with the predomince of hedge borrowing will face a situation where equilibrium is sought. The opposite applies for speculative and Ponzi-dominated economies with the result of an overly amplified economic system (Palley 2012, p. 3). It took a long time for the capitalist market to move from the stable hedge-based finance to a speculative and Ponzi-based finance system.
Economic instability and financial crisis comes when money equilibrium on the financial markets, which has been stable for a long time, becomes unsustainable. Similar situation was witnessed during the 2008 global financial crisis. The Minsky’s financial instability hypothesis is based on the premise that successful economies can lead to a financial crisis. The hypothesis can be approached considering two factors (Papadrimitriou & Wray 1999, p. 4). The first is the endogenous process in the economy, which brings a state of equilibrium, which can be seen to be static in nature. The second view is that based on endogenous process that exacerbates businesses into endless cycles and which itself breads instability in the economy. The outcome is an economy moving from stability to instability as the circulation of cheaper money becomes high, and lenders and borrowers become more reckless in their activities.
The financial stability hypothesis is characterized by a number of unregulated activities of financiers and borrowers on the market. The first characteristic of an economic meltdown is a stable environment where banks are lending money to borrowers for various reasons. As far as there is much hope to succeed tomorrow, the interest rates are lowered to allow people and businesses to borrow more. The lending itself is premised against defaults such as banks lending out mortgages hoping that the borrowers can maintain a steady flow of mortgage repayment. In this case, they set a low interest on mortgage so that more people can afford it. Because of the increased circulation of cheap money in the financial system, borrowers and lenders are willing to take on greater risks being optimistic that the financial market will continue to perform well in the future. In the process, banks are willing to accept smaller deposits leaving a huge chunk of money in the system. Lending becomes more leveraged on the ability to repay capital together with the interest. Ragupathy and Velupillai (2012, p. 2) observe that “Higher leverage ratios that result from the self-sustaining boom also stretch margins of safety and make the economy more susceptible to negative shocks.”
The other characteristic is the increase in the price of assets, because as there is more money in the financial system, people tend to invest in buying long-term assets like houses. The result is an increased confidence of banks and other financial stakeholders as both borrowers and lenders use the past to guide their future investments (Tarassow 2011, p. 9). The irrational exuberance leads to a situation where even established financial institutions believe that the crowd cannot be wrong; thus, the financial market moves where the crowd is going.
The result is a speculative lending where financial institutions and banks give money to borrowers with the expectation that the price of assets will continue to rise and borrowers will be able to repay their loans. Because of the irrational exuberance, regulatory institutions like central banks and credit rating agencies engage into unsustainable speculative lending. The investment into assets cannot be sustained for a long time, because the expectations of the lenders and borrowers are unreasonable and the prices rise not rationally in terms of the actual value. The realization by lenders that they cannot meet the repayment of capital leads to liquidating the assets to meet the requirements at hand, which causes the credit crunch and subsequent financial crisis (Minsky 1992, p. 11).
The Minsky’s financial instability hypothesis is based on a number of assumptions which exist in a capitalistic market. The first assumption is that lenders and borrowers are excited about the availability of the cheaper money in the economic system. The second assumption is that regulation agencies are also swayed by the excitement in the financial market. As a result, they prefer to wait while the financial institutions find more ways of lending out money to borrowers expecting that interest rates will improve in the nearest future (Venziani 2002, p. 7).
Borrowers are also assumed to invest the borrowed money in long-term projects, which cannot be sustained for a long period. In the case of the 2008 financial crisis, many people who had borrowed money from subprime lenders bought houses. This led to the peak in home ownership, which led to the fall in house prices (Vercelli 2009, p. 17). The rising interest rates make subprime borrowers unable to repay their loans and thus default. On the other hand, the lenders become illiquid since they cannot recover the loans given to defaulting borrowers.
Relevance of Minsky’s Financial Instability Hypothesis to 2008 Financial Crisis
Minsky’s financial instability theory can be used to explain the 2008 financial crisis that started in the United States and spread across the world. Prior to the global financial crisis, world financial market and the US one in particular was depended on deregulation by the central banks. However, as the lenders under the guidance of the US leading financial institutions became reckless and borrowers excited about the cheaper money, speculative borrowing became unsustainable. As a result, the world witnessed a free fall of the financial markets. During the period between 2004 and 2007, there was an intense movement from hedge lending to speculative lending by major leading financial institutions in America (Keen 2011, p. 2).
The subprime lenders created a secondary market where loans were developed and distributed to lenders. The result was the spiraling of asset prices, including houses, which went above the real income ratios. The growth in housing and subsequent consumer confidence continued even when the regulatory agencies like Central Bank and the Security Exchange Commission failed to regulate the deficits created by financial institutions. As noted by Basu & Oh (2011, p. 45), the “deficits in contractions sustain profits, which helps the system avoid interactive defaults that can change a downturn into a depression.”
One of the important aspects of the 2008 financial crisis was the role of the Central Federal Bank and financial regulatory agencies in the United States. According to the Minsky’s financial instability hypothesis, central banks and financial regulatory institutions often fail to control financial borrowing and lending on the market. The reason is that financial players including banks and borrowers always find loopholes in financial regulations, which they take advantage of (Keen 2011, p. 45). The other reason is that central banks and financial regulatory agencies engage in the speculative lending going on in the market and hope that the economics will sustain the amount of money in the system. In the case of the 2008 financial crisis, the Securities and Exchange Commission allowed subprime lenders including the Lehmann Brothers to lower the interest rates on the borrowed money. Hence, this caused a rush among business people who invested their money in housing saturating the sector.
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The process of regulatory relaxation took place in three stages as envisaged in the Minsky’s financial instability hypothesis. Prior to the financial crisis of 2008, the Wall Street experienced unprecedented lobbying from financial regulatory institutions like the Securities and Exchange Commission, the Federal Reserve, and the Treasury Department allowing both lenders and borrowers to access money at lower interest rates. There was also a relapse in the enforcement of the financial regulatory rules guided by a public euphoria over the booming economy and heightened economic activities in the country. As a result, there was a general willingness to relax the regulations based on the assumption that the financial system in the country was capable of sustaining itself without a strict enforcement of regulations. The increased availability of money raised tremendously the price of assets leading to unsustainable development of assets. In the case of 2008 financial crisis, the housing development peaked with 70 percent of the country’s development in 2005. The amount of cash flow in the financial system exceeded the hedge finance level, which is needed to meet the payment commitments and debts from lenders and borrowers (Whalen 2002, p. 2).
The result of speculative financing in the US led to over-indebtedness of the borrowers and a rush to sell the assets due to the public panic. Further speculation that financiers had no liquid cash to sustain the level of borrowing made borrowers sell off their assets. Also, many people gained opportunity to invest in assets which caused imbalance in the cash flow and hence a fall in the present value of the money that financial institutions were holding. The lenders were unable to recover their loans from defaulting borrowers; however, the present value did not match the value they had speculated to receive when borrowers repaid their loans. The availability of many investment opportunities had created over-indebtedness on the part of the business people with an appetite for profitable investment (Wray & Tymoigne 2008, p. 4). According to Minsky’s financial instability theory, a situation was created where hedge finance was focused on advancing the capital market and thereby increasing speculation and Ponzi financing. With the realization that the financial system was not able to validate the existing debt levels, a free fall in confidence led to the economic contraction and debt-deflation situation.
From the above analysis of the Minsky’s financial instability hypothesis, it is evident that a stable economy must be destabilized at some point. This occurs especially in a capitalistic economic where both the lenders and borrowers want to make quick profits. The genesis is a creation of the situation where the borrowers are driven to make huge borrowing, and financial lenders give out money on cheaper interest rates. The result is over-confidence in the financial system which leads to further borrowing and lowering of interest rates to encourage the exchange of money. In the meantime, the regulators relax the regulations for lending and borrowing, allowing financial institutions to innovate ways to give out money to borrowers at higher profits. In the case of the 2008 financial crisis, the Securities and Exchange Commission as well as the Federal Reserve lowered the interests charged by subprime financial institutions. Furthermore, banks were left to create shadow financial systems where they originated and distributed securitized assets with the aim of selling them off to buyers in the market. As a result, virtual economic stability was created which could not be sustained even though the investments started to lose value and borrowers rushed to sell them off. During 2008 financial crisis, the financial bubble burst in the housing sector which had seen a dramatic boom during the stable times.