WEBVTT NOTE An Empirical Examination of Minsky’s Financial Instability Hypothesis 1 00:00:00.000 --> 00:00:05.500 Loweyheim and Minsky was a leading Keynesian and post-Keynesian economist throughout his career. 2 00:00:05.500 --> 00:00:12.000 After receiving a bachelor's in math from the University of Chicago and a Ph.D. in economics from Harvard, 3 00:00:12.000 --> 00:00:18.500 he taught at Brown University, the University of California at Berkeley, and Washington University of St. Louis. 4 00:00:18.500 --> 00:00:24.500 He finished his career at the Jerome Levy Economics Institute at Bard College. 5 00:00:24.500 --> 00:00:34.500 Minsky framed the financial instability hypothesis in terms of the three types of firms defined according to the relationship between operating cash flows and debt. 6 00:00:34.500 --> 00:00:40.500 Hedge firms generate cash flows sufficient to cover both interest and principal on their debt. 7 00:00:40.500 --> 00:00:47.500 Speculative firms generate cash flows sufficient to service interest but not to pay down principal. 8 00:00:47.500 --> 00:00:52.500 Consequently, these firms must constantly refinance existing debt. 9 00:00:52.500 --> 00:01:07.500 An extreme case of the speculative firm is the Ponzi firm, for which cash flows are inadequate to service even interest alone. Ponzi firms must sell off assets or face bankruptcy. 10 00:01:07.500 --> 00:01:16.500 The essence of the financial instability hypothesis is that as prosperity lengthens, firms lose their memory of the risks inherent in borrowing. 11 00:01:16.500 --> 00:01:26.500 As firms borrow more, hedge firms become speculative and speculative firms become Ponzi's, exposing the financial sector to ever higher risk. 12 00:01:26.500 --> 00:01:40.500 Eventually, speculative and Ponzi firms have to sell off assets to service their debt, causing asset prices to plummet, a process Minsky called debt deflation. 13 00:01:40.500 --> 00:01:47.500 This is a special case of the more general process Austrian business cycle theory calls malinvestment liquidation. 14 00:01:47.500 --> 00:01:54.500 Assets sold off at sharply reduced prices could be business units, physical plant or financial assets. 15 00:01:54.500 --> 00:02:00.500 The point in time when asset sell-off results in debt deflation has been dubbed the Minsky moment. 16 00:02:00.500 --> 00:02:08.500 The percentage of speculative and Ponzi firms falls during recovery from a recession but rises approaching the next, 17 00:02:08.500 --> 00:02:16.180 Next, providing a characteristic U-shape which can be examined empirically. 18 00:02:16.180 --> 00:02:22.200 We use interest coverage to distinguish among hedge, speculative and Ponzi firms. 19 00:02:22.200 --> 00:02:27.420 Interest coverage is defined as the sum of net income and interest expense divided by 20 00:02:27.420 --> 00:02:29.220 interest expense. 21 00:02:29.220 --> 00:02:34.380 We selected an arbitrary value of 4 for this ratio to distinguish hedge from speculative 22 00:02:34.380 --> 00:02:52.700 First we plot the percent of all 8,707 publicly traded equities listed in Compustat. The characteristic 23 00:02:52.700 --> 00:02:57.440 use pattern is clear, though the upward sloping gradient approaching the current recession 24 00:02:57.440 --> 00:03:01.860 is not very steep. And this dates, you know, you probably cannot read the dates along the 25 00:03:01.860 --> 00:03:10.860 in the bottom, but it goes from the trough of the last recession in the first quarter of 2002 until the last quarter of 2009. 26 00:03:10.860 --> 00:03:19.860 And you can see an upward sloping gradient, this is a percentage, so everything adds up to 100% of all the firms listed, 27 00:03:19.860 --> 00:03:26.860 but the number of speculative firms declines as we recover from the last recession, then it starts to rise again. 28 00:03:26.860 --> 00:03:33.860 It's real clear that we get a sharp spike at this point, but this is associated with the financial crisis. 29 00:03:33.860 --> 00:03:40.860 What's more important would be the supposed upward slope here, which would give us advance warning. 30 00:03:40.860 --> 00:03:51.860 And it's real clear to me that it's there. It's not real clear to some referees that it's there, but that's economic research. 31 00:03:51.860 --> 00:04:10.860 More firms go public as the expansion lengthens and the total number listed only falls after the recession starts in December 2007, dropping off drastically due to the financial crisis in December 2008. 32 00:04:10.860 --> 00:04:40.860 Now, this is the same data, but it's graphed as a total number of firms in each category, irrespective of size, so they're all weighted equally, you know, GM versus, you know, the, well, GM is not a good example, excuse me, General Electric versus, you know, the dinkiest little startup, and in this case, we can notice that the financial crisis also accounts for large numbers of hedge firms becoming speculative 33 00:04:40.860 --> 00:05:03.860 Hedge firms account for about 70% of market value prior to the financial crisis, but the percent of total value imputed to speculative and Ponzi finance units rises dramatically as we enter the recession and peaks during the financial crisis. 34 00:05:03.860 --> 00:05:14.860 And this is where they're weighted by market value, but it's as a percentage of total market value, irrespective of the fact that this changed. 35 00:05:14.860 --> 00:05:27.860 And now this graph only starts in 2006 because Compustat didn't include the market value, market capitalization item for each stock until after that point. 36 00:05:27.860 --> 00:05:40.860 So it's only fairly late in the run-up toward the current recession, going up to approximately the present, last available observation in CompuStat. 37 00:05:40.860 --> 00:05:48.860 The percentage of speculative and Ponzi firms rises entering the recession as more firms over leverage themselves. 38 00:05:48.860 --> 00:05:55.860 Then when the financial crisis occurs, significant numbers of hedge firms become speculative and Ponzis. 39 00:05:55.860 --> 00:06:05.860 Most of the rather spectacular 8 trillion dollar loss of market value comes out of the hedge finance units because that's where all the money is. 40 00:06:05.860 --> 00:06:19.860 Here we can see this is the market value so each firm is weighted by its current market capitalization as valued efficiently to some extent by the stock market. 41 00:06:19.860 --> 00:06:26.300 Market, but hedge sector value peaks first in June 2007, about six months before the 42 00:06:26.300 --> 00:06:30.820 start of the recession in December 2007. 43 00:06:30.820 --> 00:06:35.620 The speculative sector peaks about the same time as the start of the recession, certainly 44 00:06:35.620 --> 00:06:43.100 by January 2008, and the Ponzi sector down at the bottom peaks in October 2008, about 45 00:06:43.100 --> 00:06:45.940 two months prior to the financial crisis. 46 00:06:45.940 --> 00:06:51.040 As the recession deepened, hedge firms were transformed into speculative and Ponzi's, 47 00:06:51.040 --> 00:06:55.200 not so much through obtaining additional leverage, which wasn't really too available, but more 48 00:06:55.200 --> 00:06:59.680 due to declining revenues. 49 00:06:59.680 --> 00:07:04.100 It is notable that the interest coverage for all types of firms begins to fall in absolute 50 00:07:04.100 --> 00:07:10.460 value by 2005 to 2006, well before the onset of the current recession. 51 00:07:10.460 --> 00:07:19.620 This seems to be the best early warning indicator of a coming downturn. 52 00:07:19.620 --> 00:07:24.340 Debt to equity ratios offering an alternative approach to categorizing the firms according 53 00:07:24.340 --> 00:07:31.740 to Minsky category also display the characteristic U-curve pattern except for the fourth quartile 54 00:07:31.740 --> 00:07:37.420 representing the most over leveraged firms dominated by extreme outliers. 55 00:07:37.420 --> 00:07:43.620 Ponzi firms have negative DE ratios, debt-to-equity ratios. 56 00:07:43.620 --> 00:07:50.060 The same patterns are evident for these firms except, of course, in the first quartile they're 57 00:07:50.060 --> 00:07:55.620 washed out by extreme outliers. 58 00:07:55.620 --> 00:08:01.260 Now doing the same analysis for the S&P 500, when we look at the larger firms, classifying 59 00:08:01.260 --> 00:08:07.260 them once again according to interest coverage, we see the same characteristic U pattern. 60 00:08:07.260 --> 00:08:13.260 The gradient of the expansion phase preceding the recession is much steeper than for all listed firms. 61 00:08:13.260 --> 00:08:19.260 And I don't know that my referee could see it in this diagram, but at least he didn't complain about not being able to see it. 62 00:08:19.260 --> 00:08:27.260 We suggest that this is due to the alternative sources of funds, such as corporate bonds and commercial paper, 63 00:08:27.260 --> 00:08:35.260 to which the larger firms have access. Their ability to substitute sources of funds makes lenders more reluctant to withhold credit, 64 00:08:35.260 --> 00:08:42.260 facilitating their ability to achieve the state of over leverage the Financial Instability Hypothesis calls for. 65 00:08:42.260 --> 00:08:55.260 Total market value is increasingly dominated by hedge firms and the percent of market value imputable to speculative and Ponzi firms declines prior to and during the current recession. 66 00:08:55.260 --> 00:09:05.260 Total market value for the S&P 500 peaks first for the Ponzi firms over a year before the onset of the recession. 67 00:09:05.260 --> 00:09:13.260 Total value peaks for the speculative firms about April 2007 and for hedge firms about January 2008, 68 00:09:13.260 --> 00:09:19.260 roughly contemporaneous with the start of the recession, dated to December 2007. 69 00:09:19.260 --> 00:09:26.260 For all listed firms, the pattern was reversed and that the hedge firms peaked first and the Ponzi's last. 70 00:09:26.260 --> 00:09:34.260 So for larger firms, we see a very different way that this over leverage develops. 71 00:09:34.260 --> 00:09:44.260 For large firms, the speculative sector has the lowest volatility until after the second quarter of 2005. 72 00:09:44.260 --> 00:09:54.260 These firms become increasingly more volatile until the middle of 2008 after the recession started, but before the financial crisis. 73 00:09:54.260 --> 00:10:00.260 As the economy approached the financial crisis, value volatility of all firms decreased markedly. 74 00:10:04.260 --> 00:10:13.260 Little that has occurred between 2002 to 2009 cannot be readily interpreted in terms of the financial instability hypothesis. 75 00:10:13.260 --> 00:10:19.180 Support for the Financial Instability Hypothesis was more pronounced among large firms, which 76 00:10:19.180 --> 00:10:25.060 we attribute to their access to more alternatives to finance over-leveraging. In terms of Austrian 77 00:10:25.060 --> 00:10:31.420 Business Cycle Theory, credit expansion amplifies the Financial Instability Hypothesis, assuming 78 00:10:31.420 --> 00:10:36.500 that it can in fact occur on its own in the absence of credit expansion, which has to 79 00:10:36.500 --> 00:10:42.740 be an open question. This encourages over-leverage by making borrowing artificially cheap. Credit 80 00:10:42.740 --> 00:10:48.500 Expansion provides the initial funds necessary for over leverage, at the same time the low 81 00:10:48.500 --> 00:10:54.680 interest rate in engenders discourages savings. Since 1980 all the monetary aggregates have 82 00:10:54.680 --> 00:11:01.260 grown at an average rate of approximately 10% per year, therefore we suggest empirical 83 00:11:01.260 --> 00:11:06.420 support for the financial instability hypothesis is also support for Austrian business cycle 84 00:11:06.420 --> 00:11:14.180 Theory. And I've probably got Mises and Minsky spinning in their graves by saying that, but 85 00:11:14.180 --> 00:11:15.500 there it is.