Can "It" Happen Again?

1. Capitalism is inherently unstable due to financial dynamics.

Whilst the processes that cause financial instability are an inescapable part of the capitalist economy, Minsky also argues that financial instability need not lead to a great depression.

Inherent flaw. Minsky argues that financial instability is not an accident or an external shock but an intrinsic feature of decentralized capitalist economies. Unlike neoclassical theories that assume inherent stability, Minsky's Financial Instability Hypothesis (FIH) posits that the very mechanisms of finance, credit, and investment within capitalism naturally lead to periods of excessive risk-taking and eventual fragility. This perspective challenges the notion that market forces alone can ensure long-term equilibrium and stability.

Cyclical nature. The economy's cyclical behavior, characterized by booms and busts, is a direct consequence of how investment and asset ownership are financed. As periods of economic tranquility lengthen, market participants become complacent, leading to an endogenous shift in financial practices towards more precarious forms. This internal dynamic means that stability itself breeds instability, setting the stage for future crises.

Beyond equilibrium. Minsky's theory moves beyond static equilibrium models, emphasizing that the economy exists in historical time, where past decisions and evolving financial structures continuously shape future outcomes. This dynamic, path-dependent nature means that financial crises are not anomalies but rather predictable, albeit not deterministic, outcomes of the capitalist process, requiring a different theoretical framework to understand and manage.

2. The "Minsky Moment" describes the endogenous shift to financial fragility.

Indeed, the Minsky moment has become a fashionable catch phrase on Wall Street.

From stability to fragility. The "Minsky Moment" refers to the point when a prolonged period of economic prosperity and stability encourages excessive risk-taking and debt accumulation, eventually leading to a sudden, sharp collapse in asset values and a financial crisis. This transition is endogenous, meaning it arises from within the system itself, as success erodes the perception of risk. As the economy thrives, financial institutions and businesses become increasingly confident, leading them to take on more leverage and engage in more speculative financing.

Erosion of caution. During tranquil periods, the memory of past crises fades, and the margins of safety built into financial structures are gradually eroded. What was once considered prudent becomes overly cautious, and new, riskier financial instruments and practices emerge and proliferate. This "euphoric" phase sees a rapid expansion of debt-financed investment and asset positions, pushing asset prices higher and further encouraging speculative behavior.

The breaking point. This escalating fragility continues until a triggering event—which might be minor in isolation—causes a sudden re-evaluation of risk. This re-evaluation leads to a scramble for liquidity, a sharp decline in asset prices, and a widespread inability to roll over or refinance maturing debts. The "Minsky Moment" is thus the abrupt shift from perceived stability to overt instability, often marking the onset of a financial crisis.

3. Three types of finance define systemic risk: Hedge, Speculative, and Ponzi.

The stability of an economy’s financial structure depends upon the mix of financial postures.

Categorizing debt. Minsky categorizes financial postures into three types based on a unit's expected cash flows relative to its debt payment commitments. This framework is crucial for assessing the overall fragility of the financial system. The greater the proportion of speculative and Ponzi finance, the more vulnerable the economy becomes to disturbances.

Hedge finance. In hedge finance, expected cash flows from operations are sufficient to cover both principal and interest payments on debt in every period. These units are robust and can withstand economic downturns without defaulting. They represent the most stable form of financing, relying on predictable income streams to meet obligations.

Speculative and Ponzi finance. Speculative finance units can cover interest payments from cash flow but must roll over or refinance principal. They are vulnerable to rising interest rates or tightening credit conditions. Ponzi finance units cannot even cover interest payments from cash flow, requiring them to borrow more simply to service existing debt. Their viability depends entirely on asset appreciation or continuous refinancing, making them extremely fragile and susceptible to collapse if asset prices fall or credit dries up.

4. Government deficits and central bank interventions prevent deep depressions.

The combination of refinancing by lender-of-last-resort interventions and the stabilizing effect of deficits upon profits explain why we have not had a deep depression since World War II.

Post-WWII success. The absence of a deep, prolonged depression since World War II is attributed to the significantly expanded role of government and the Federal Reserve. Unlike the 1930s, when government was small and central bank action timid, modern interventions have created a safety net that prevents financial crises from spiraling into catastrophic economic collapses. This "big government" acts as a crucial stabilizer.

Fiscal stabilizers. Government deficits play a vital role by sustaining aggregate demand and, critically, business profits during downturns. When investment falls, automatic stabilizers (like unemployment benefits) and discretionary fiscal policies (like tax cuts) lead to a surge in government spending relative to tax revenues, creating large deficits. These deficits inject cash into the economy, preventing a collapse in overall business profitability, which is essential for debt validation.

Lender of last resort. The Federal Reserve's aggressive and timely interventions as a lender of last resort have been equally important. By providing liquidity and guarantees to distressed financial institutions and markets, the Fed prevents widespread bankruptcies and a cascading debt-deflation process. These interventions stabilize asset values and ensure that financial markets continue to function, albeit sometimes at the cost of future inflation.

5. Sustained profits are crucial for validating debt and driving investment.

Profits are critical in a capitalist economy because they are a cash flow which enables business to validate debt and because anticipated profits are the lure that induces current and future investment.

The pivot of capitalism. In Minsky's framework, gross profits (broadly defined as capital income after taxes and interest) are the central determinant of a capitalist economy's stability. Profits serve a dual function: they provide the cash flow necessary for businesses to meet their contractual debt obligations, thereby validating the financial structure, and they act as the primary incentive for new investment. Without sufficient and stable profit flows, the entire system of debt-financed investment falters.

Profits and investment. Minsky, drawing on Kalecki, posits that aggregate profits are largely determined by investment and government deficits. Specifically, "After Tax Profits = Investment + The Government Deficit – The Balance of Trade Deficit + Consumption Out of Profit Income – Saving Out of Wage Income." This equation highlights how external demand sources, particularly investment and government spending, directly generate the profits that sustain the financial system.

Validation and expectations. The ability of current profits to validate past debt commitments directly influences the long-term expectations of businesses and bankers. When profits are robust, confidence in future profitability grows, encouraging further debt-financed investment. Conversely, a decline in profits undermines this confidence, making it harder to secure new financing and potentially triggering a debt-deflation spiral. Sustaining profits, therefore, is paramount for economic stability.

6. Conventional monetary policy is often ineffective and can trigger crises.

Monetary constraint in a situation in which ongoing investment activity leads to a rising demand for finance is effective only as it forces a sharp break in asset values caused by market pressures to liquidate or fund positions.

Limited efficacy. Minsky argues that conventional monetary policy, focused on controlling the money supply or interest rates, is often ineffective in managing a financially fragile economy. During euphoric booms, the demand for financing can be highly inelastic, and financial innovations can rapidly increase the velocity of money, circumventing central bank attempts to restrict credit. This means that simply raising interest rates may not smoothly curb inflation or investment.

Crisis as a tool. Instead, monetary constraint in a fragile system often works by pushing the economy to the brink of a financial crisis. By making refinancing difficult and increasing the cost of debt, the central bank can force a "sharp break in asset values" as units are compelled to liquidate positions. This disruption shatters euphoric expectations and forces a re-evaluation of risk, which is the true mechanism by which tight money can halt an unsustainable expansion.

The dilemma. This creates a dilemma for central banks: they must either allow an inflationary boom to continue or risk triggering a financial crisis to rein it in. The experience since the mid-1960s shows that the Federal Reserve has repeatedly chosen the latter, intervening as a lender of last resort after a crisis threatens, thereby preventing a full collapse but often setting the stage for renewed inflationary pressures.

7. Stagflation is the price of avoiding deep depressions.

Stagflation is truly a result of big government, but so is the absence of a deep depression in the years since 1966.

The trade-off. Minsky posits that the success in preventing deep depressions since World War II has come at a cost: the emergence of chronic inflation and stagflation (simultaneous high inflation and unemployment). The very interventions designed to stabilize the economy and sustain profits during downturns—namely, large government deficits and central bank liquidity injections—also fuel inflationary pressures.

Inflationary validation. When government deficits sustain profits even as investment or productivity growth falters, prices tend to rise. This "inflationary validation" allows inefficient business structures and poorly chosen investments to persist, as the rising nominal value of profits helps meet debt commitments. This process, where nominal profits are sustained by deficits rather than real productivity gains, leads to higher prices without corresponding increases in output or employment.

Inefficiency and turbulence. The continuous need for interventions to abort financial crises, coupled with the inflationary consequences, creates an environment of economic turbulence. This discourages prudent, long-term investment and fosters short-run speculation, contributing to declining productivity growth and persistent unemployment alongside rising prices. Stagflation, therefore, is not just a policy failure but a systemic outcome of managing an inherently unstable capitalist economy with "big government" interventions.

8. Financial markets evolve, increasing systemic vulnerability over time.

As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever.

Dynamic evolution. Financial markets are not static; they constantly evolve in response to profit opportunities and changing perceptions of risk. During prolonged periods of economic expansion, this evolution tends to increase systemic vulnerability. New financial instruments and institutions emerge, and existing ones are used in increasingly aggressive ways, all aimed at leveraging perceived opportunities.

Liquidity erosion. This evolution often involves "velocity-increasing and liquidity-decreasing money-market innovations." For example:

• The growth of the federal funds market.
• The rise of commercial paper.
• The proliferation of negotiable Certificates of Deposit (CDs).
  These innovations allow a given amount of money to support a larger volume of transactions, effectively increasing the velocity of money. However, they also reduce the overall liquidity of the system, making it more susceptible to shocks.

Compounding fragility. As financial layering increases and the proportion of "protected" (government-backed) assets in portfolios declines relative to "inside" (private) assets, the financial system becomes progressively more fragile. This means that smaller disturbances can have larger, more widespread impacts, increasing the likelihood that a seemingly minor event could trigger a full-blown financial crisis. The very success of the economy in avoiding crises encourages this dangerous evolution.

9. Asset prices and investment are driven by subjective expectations and financing.

In a world with capitalist financial usages, uncertainty—in the sense of Keynes—is a major determinant of the path of income and employment.

Two price systems. Minsky emphasizes that a capitalist economy operates with two distinct price systems: one for current output (goods and services) and another for capital assets (stocks, bonds, real estate). The prices of current output are influenced by short-run expectations and production costs, while capital asset prices are driven by long-run expectations of future profits and the subjective valuation of liquidity in an uncertain world.

Uncertainty and animal spirits. Investment decisions, which are crucial for aggregate demand, are fundamentally speculative. They are made under "intractable uncertainty," meaning future outcomes cannot be reliably predicted with probabilities. This uncertainty makes expectations highly subjective and prone to rapid shifts, influenced by "animal spirits"—waves of optimism or pessimism among entrepreneurs and financiers. These shifts directly impact the market valuation of capital assets.

Financing as a determinant. The availability and terms of financing are equally critical. The price of capital assets, which dictates the demand for new investment, is heavily influenced by how easily positions in these assets can be financed. As financial markets evolve and risk perceptions change, the willingness to lend and borrow shifts, directly affecting asset prices and, consequently, the pace of investment. This interplay between subjective expectations, asset prices, and financing conditions makes investment inherently volatile.

10. Structural reforms are needed to achieve lasting economic stability.

Substantial improvement is possible only if the spending side of government and the domain of private investment are restructured.

Beyond quick fixes. Minsky concludes that the recurring cycle of inflation, financial turbulence, and stagnation cannot be resolved by simple monetary or fiscal "fine-tuning." Instead, fundamental structural reforms are necessary to address the inherent instability of capitalism. These reforms must aim to create a "good financial society" that constrains the tendency towards speculative finance and reorients economic activity.

Reforming government and industry. Key areas for reform include:

• Government spending: Shifting from consumption- and defense-oriented spending to resource creation and infrastructure development, which enhances the efficiency of private capital.
• Transfer payments: Reforming welfare systems to remove barriers to work and promote labor force participation.
• Market power: Breaking the market power of giant corporations through robust antitrust policies to prevent inflationary absorption of demand-sustaining measures.
• Capital-intensive industries: Considering public ownership and operation for highly capital-intensive industries (e.g., railroads, nuclear power) where private financing struggles to align social benefits with market returns.

Simplifying finance. A crucial reform involves restructuring the financial system itself to promote smaller, simpler organizations and a greater reliance on direct, less layered financing. This would reduce the systemic fragility that leads to crises. Minsky acknowledges that enforcing such simplicity would be challenging but essential for achieving greater stability without resorting to chronic inflation or deep depressions. The goal is not to eliminate capitalism but to create a more robust and resilient version.

Last updated: December 23, 2025