Hyman Minsky is in the news again. After sitting on the sidelines of mainstream economics for most of his career, his ideas now pop up on a regular basis as analysts (and journalists) look back and try to make sense of the financial crisis.

Hyman Minsky

“Minsky’s main idea is so simple that it could fit on a T-shirt, with just three words,” writes Duncan Wheldon for the BBC. “Stability is destabilising.”

Theorists (not only economists) are often attracted to equilibrium models because they are analytically tractable, and theoreticians need something to show at the end of the day just like the rest of us. If you can justify washing out transient effects and are willing to discount feedback, then everything should be fine.

Under this paradigm, shocks always come from outside the system, either some external event that economics couldn’t have foreseen (war, famine) or some new kind of interaction (sweeping regulatory change, the appearance of a new economic power). But the system itself is assumed to be stable as long as nothing knocks it off track.

Hyman Minsky: Complacence breeds risk

Minsky rejected this simplification, arguing that the amount of risk grows during times of stability until it becomes too much for the system to stand and everything falls apart. The mechanism is straightforward, as investments pay off and profits grow, people become complacent. Their perception of risk diminishes, and they become more willing to move out on the risk curve.

In the case of banks, Minsky imagined three distinct phases: shortly after a crisis, banks would only be willing to lend to debtors with plenty of capital and the ability to pay back the loan in full. Eventually, as fears subside, they will start making speculative loans to businesses that can only repay interest on the hopes that their earning power (or the value of underlying assets) will catch up with loan payments in the future. Finally, they start making ‘Ponzi’ loans to businesses that can’t be reasonably expected to even make the interest payments. At this point (think sub-prime mortgages circa 2007) a crash is just around the corner.

Applying Minsky to Fannie Mae, Freddie Mac reform

One current application of Minsky’s ideas is to the Johnson-Crapo proposal for Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) reform that has been floating around. The 10% capital requirements might be high enough in case of another mortgage crisis, but some critics have pointed out that they are unreasonably high as long as lenders are responsible and underwriting quality stays high. If you believe Minsky, then Johnson and Crapo have the right idea, setting capital requirements high enough to (hopefully) prepare for the inevitable slide into higher risk.