The Financial Instability Hypothesis -- a hypothesis on how we have gotten here.

One explanation (hypothesis) on how we ended up in this recession:

The Financial Instability Hypothesis was founded by Chicago native Hyman Minsky.

"Dr. Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles endogenous to financial markets. Minsky claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.

This slow movement of the financial system from stability to crisis is something for which Minsky is best known, and the phrase "Minsky moment" refers to this aspect of Minsky's academic work.

Disagreeing with many mainstream economists of the day, he argued that these swings, and the booms and busts that can accompany them, are inevitable in a free market economy, unless government steps in to control them, through regulation, central bank action and other tools; such mechanisms, in fact, came into existence in response to crises such as the Panic of 1907 and the Great Depression. He opposed the deregulation that characterized the 1980s.

"A fundamental characteristic of our economy," Minsky wrote in 1974, "is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles." - Wikipedia

Now that you have a brief history, let's now explain FIH In Layman's terms:

a)in good times, when investment and spending is abundant, over confidence develops
b)as a result, financial institutions and others become more indebted (over leveraged)
-leverage - borrow a lot to finance other activities
c)financial structures then become "fragile"
d)when a "shock" comes (anything that greatly disturbs the economic equilibrium) a financial
crisis ensues disrupting intermediation
-intermediation - borrowing & lending
e)thus consumption & investment (C + I) decreases and sends the economy into a recession

This process becomes cyclical. Why? Although technology improves, overconfidence can still develop because of easier procedures of intermediation.

Standard criticism is that this hypothesis seems irrational. Because why would rational people continue to make the same mistake (overconfidence, providing lending tools for unqualified individuals, etc, etc)?

Good question indeed.


Hyman Minsky - http://en.wikipedia.org/wiki/Hyman_Minsky

Intermediation - http://en.wikipedia.org/wiki/Intermediation