Working Paper No. 74
The Financial Instability Hypothesis*byHyman P. Minsky
The Jerome Levy Economics Institute of Bard CollegeMay 1992

* Prepared for Handbook of Radical Political Economy, edited by Philip Arestis and Malcolm Sawyer, Edward
Elgar: Aldershot, 1993.

The Levy Economics Institute Working Paper Collection presents research in progress by
Levy Institute scholars and conference participants. The purpose of the series is todisseminate ideas to and elicit comments from academics and professionals.
Levy Economics Institute of Bard College, founded in 1986, is a nonprofit,
nonpartisan, independently funded research organization devoted to public service.
Through scholarship and economic research it generates viable, effective public policy
responses to important economic problems that profoundly affect the quality of life in
the United States and abroad.
Levy Economics InstituteP.O. Box 5000
Annandale-on-Hudson, NY 12504-5000
http://www.levyinstitute.org
Copyright © Levy Economics Institute 1992–2013 All rights reserved
ISSN 1547-366X

The financial instability hypothesis has both empirical andtheoretical aspects.

The readily observed empirical aspect isthat, from time to time, capitalist economies exhibit inflationsand debt deflations which seem to have the potential to spin outof control.

In such processes the economic system's reactions toa movement of the economy amplify the movement--inflation feeds
upon inflation and debt-deflation feeds upon debt-deflation.
Government interventions aimed to contain the deterioration seemto have been inept in some of the historical crises.

These

historical episodes are evidence supporting the view that theeconomy does not always conform to the classic precepts of Smithand Walras: they implied that the economy can best be understoodby assuming that it is constantly an equilibrium seeking andsustaining system.
The classic description of a debt deflation was offered byIrving Fisher (1933) and that of a self-sustaining
disequilibrating processes by Charles Kindleberger (1978).
Martin Wolfson (1986) not only presents a compilation of data on
the emergence of financial relations conducive to financial
instability, but also examines various financial crisis theories
of business cycles.
As economic theory, the financial instability hypothesis is
an interpretation of the substance of Keynes's "General Theory".
This interpretation places the General Theory in history.

As theGeneral Theory was written in the early 193Os, the great
financial and real contraction of the United States and the other1

capitalist economies of that time was a part of the evidence thetheory aimed to explain.

The financial instability hypothesis

also draws upon the credit view of money and finance by Joseph
Schumpeter (1934, Ch.3)

Key works for the financial instability

hypothesis in the narrow sense are, of course, Hyman P. Minsky(1975, 1986).
The theoretical argument of the financial instability
hypothesis starts from the characterization of the economy as acapitalist economy with expensive capital assets and a complex,
The economic problem issophisticated financial system.

identified following Keynes as the "capital development of theeconomy," rather than the Knightian "allocation of given
resources among alternative employments."

The focus is on an

accumulating capitalist economy that moves through real calendartime.
The capital development of a capitalist economy isaccompanied by exchanges of present money for future money.

The

present money pays for resources that go into the production ofinvestment output, whereas the future money is the "profits"
which will accrue to the capital asset owning firms (as thecapital assets are used in production).

As a result of theprocess by which investment is financed, the control over itemsin the capital stock by producing units is financed byliabilities--these are commitments to pay money at dates
specified or as conditions arise.

For each economic unit, theliabilities on its balance sheet determine a time series of prior2

payment commitments, even as the assets generate a time series ofconjectured cash receipts.
This structure was well stated by Keynes (1972) :There is a multitude of real assets in the world whichconstitutes our capital wealth - buildings, stocks ofcommodities, goods in the course of manufacture and of
The nominal owners of thesetransport, and so forth.
assets, however, have not infrequently borrowed money(Keynes' emphasis) in order to become possessed of them. To
a corresponding extent the actual owners of wealth have
A considerable
claims, not on real assets, but on money.
part of this financing takes place through the banking
system, which interposes its guarantee between its
depositors who lend it money, and its borrowing customers towhom it loans money wherewith to finance the purchase of
The interposition of this veil of money
real assets.
between the real asset and the wealth owner is an especiallymarked characteristic of the modern world."(p.l51)
This Keynes "veil of money" is different from the Quantity
The Quantity Theory "veil ofTheory of money "veil of money."money" has the trading exchanges in commodity markets be of goods
for money and money for goods: therefore, the exchanges arereally of goods for goods.

The Keynes veil implies that money isconnected with financing through time.

A part of the financingof the economy can be structured as dated payment commitments inwhich banks are the central player.

The money flows are firstfrom depositors to banks and from banks to firms:

then, at somelater dates, from firms to banks and from banks to theirdepositors.

Initially, the exchanges are for the financing ofinvestment,

and subsequently, the exchanges fulfill the priorcommitments which are stated in the financing contract.
In a Keynes "veil of money" world, the flow of money tofirms is a response to expectations of future profits, and the3flow of money from firms is financed by profits that arerealized.

In the Keynes set up, the key economic exchanges takeplace as a result of negotiations between generic bankers andgeneric businessmen.

The documents "on the table" in suchnegotiations detail the costs and profit expectations of thebusinessmen: businessmen interpret the numbers and theexpectations as enthusiasts, bankers as skeptics.
Thus, in a capitalist economy the past, the present, and thefuture are linked not only by capital assets and labor force
characteristics but also by financial relations.

The keyfinancial relationships link the creation and the ownership ofcapital assets to the structure of financial relations andchanges in this structure.

Institutional complexity may result

in several layers of intermediation between the ultimate ownersof the communities' wealth and the units that control and operate
the communities' wealth.
Expectations of business profits determine both the flow offinancing contracts to business and the market price of existing
financing contracts.

Profit realizations determine whether thecommitments in financial contracts are fulfilled--whether
financial assets perform as the pro formas indicated by thenegotiations.
In the modern world, analyses of financial relations andtheir implications for system behavior cannot be restricted to
the liability structure of businesses and the cash flows theyentail.

Households (by the way of their ability to borrow on4credit cards for big ticket consumer goods such as automobiles,
house purchases, and to carry financial assets), governments(with their large floating and funded debts), and internationalunits (as a result of the internationalization of finance) haveliability structures which the current performance of the economy
either validates or invalidates.
An increasing complexity of the financial structure, inconnection with a greater involvement of governments as
refinancing agents for financial institutions as well as ordinary
business firms (both of which are marked characteristics of themodern world), may make the system behave differently than inearlier eras.

In particular, the much greater participation ofnational governments in assuring that finance does not degenerate
as in the 1929-1933 period means that the down side vulnerabilityof aggregate profit flows has been much diminished.

However, thesame interventions may well induce a greater degree of upside(i.e. inflationary) bias to the economy.
In spite of the greater complexity of financial relations,the key determinant of system behavior remains the level ofprofits.

The financial instability hypothesis incorporates theKalecki (1965)-Levy (1983) view of profits, in which thestructure of aggregate demand determines profits.

In theskeletal model, with highly simplified consumption behavior byreceivers of profit incomes and wages, in each period aggregate
profits equal aggregate investment.

In a more complex (thoughstill highly abstract) structure, aggregate profits equal
5aggregate investment plus the government deficit.

Expectationsof profits depend upon investment in the future, and realized
profits are determined by investment: thus, whether or notliabilities are validated depends upon investment.

Investment

takes place now because businessmen and their bankers expect
investment to take place in the future.
The financial instability hypothesis, therefore, is a theoryof the impact of debt on system behavior and also incorporates
the manner in which debt is validated.

In contrast to theorthodox Quantity Theory of money, the financial instability
hypothesis takes banking seriously as a profit-seeking activity.
Banks seek profits by financing activity and bankers. Like all
entrepreneurs in a capitalist economy, bankers are aware that
innovation assures profits.

Thus, bankers (using the term

generically for all intermediaries in finance), whether they be
brokers or dealers, are merchants of debt who strive to innovatein the assets they acquire and the liabilities they market.

Thisinnovative characteristic of banking and finance invalidates thefundamental presupposition of the orthodox Quantity Theory ofmoney to the effect that there is an unchanging "money" item
whose velocity of circulation is sufficiently close to being
constant: hence, changes in this money's supply have a linear
proportional relation to a well defined price level.
Three distinct income-debt relations for economic units,
which are labeled as hedge, speculative, and Ponzi finance, canbe identified.Hedge financing units are those which can fulfill all of
their contractual payment obligations by their cash flows: thegreater the weight of equity financing in the liability
structure, the greater the likelihood that the unit is a hedge
financing unit.

Speculative finance units are units that canmeet their payment commitments on "income account" on their
liabilities, even as they cannot repay the principle out of
income cash flows.

Such units need to "roll over" their

liabilities: (e.g. issue new debt to meet commitments on maturingdebt).

Governments with floating debts, corporations withfloating issues of commercial paper, and banks are typicallyhedge units.
For Ponzi units, the cash flows from operations are notsufficient to fulfill either the repayment of principle or theinterest due on outstanding debts by their cash flows fromoperations.

Such units can sell assets or borrow.

Borrowing to

pay interest or selling assets to pay interest (and evendividends) on common stock lowers the equity of a unit, even as
it increases liabilities and the prior commitment of future
incomes.

A unit that Ponzi finances lowers the margin of safetythat it offers the holders of its debts.
It can be shown that if hedge financing dominates, then theeconomy may well be an equilibrium seeking and containing system.
In contrast, the greater the weight of speculative and Ponzi
finance, the greater the likelihood that the economy is adeviation amplifying system.

The first theorem of the financial
7

instability hypothesis is that the economy has financing regimes
under which it is stable, and financing regimes in which it isunstable.

The second theorem of the financial instabilityhypothesis is that over periods of prolonged prosperity, theeconomy transits from financial relations that make for a stablesystem to financial relations that make for an unstable system.
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 islarge weight to units engaged in speculative and Ponzi finance.
Furthermore, if an economy with a sizeable body of speculative
financial units is in an inflationary state, and the authoritiesattempt to exorcise inflation by monetary constraint, thenspeculative units will become Ponzi units and the net worth ofpreviously Ponzi units will quickly evaporate.

Consequently,

units with cash flow shortfalls will be forced to try to makeposition by selling out position.

This is likely to lead to acollapse of asset values.
The financial instability hypothesis is a model of acapitalist economy which does not rely upon exogenous shocks togenerate business cycles of varying severity.

The hypothesis

holds that business cycles of history are compounded out of (i)the internal dynamics of capitalist economies, and (ii) thesystem of interventions and regulations that are designed to keep
the economy operating within reasonable bounds.

References
Fisher, Irving. 1933. "The Debt Deflation Theory of Great
Depressions." Econometrica 1: 337-57
Kalecki, Michal 1965.
and Unwin

Theory of Economic Dynamics. London: Allen

Keynes, John Maynard, 1936. The General Theory of Employment,Interest, and Money. New York: Harcourt Brace.
Keynes, John Maynard. 1972. Essays in Persuasion,The Collected
Writings of John Maynard Keynes, Volume IX.
MacMillan, St.
Martins Press, for the Royal Economic Society, London andBasingstoke, p 151
Kindleberger, Charles 1978. Manias, Panics and Crashes. New York,Basic Books
Levy S. Jay and David A. 1983.
Profits And The Future ofAmerican Society. New York, Harper and Row
Minsky, Hyman P. 1975. John Maynard Keynes. Columbia UniversityPress.
Minsky, Hyman P. 1986.
University Press.

Stabilizing An Unstable Economy.

Yale

Schumpeter, Joseph A. 1934. Theory of Economic Development.
Cambridge, Mass. Harvard University Press
Wolfson, Martin H. 1986. Financial Crises. Armonk New York, M.E.
Sharpe Inc.