An Empirical Examination of Minsky’s Financial Instability Hypothesis: From Market Process to Austrian Business Cycle

Abstract

AbstractMinsky proposed classifying firms in three categories: (1) hedge finance units which borrow no more than they are able to service in interest and principal out of operating cash flows, (2) speculative finance units which are overleveraged to the point where they can service interest on their debt out of operating cash flows, but cannot repay the principal, and thus must continually roll over their existing debt, and (3) Ponzi finance units, whose operating cash flows are inadequate even to service interest on their debt. In Minsky’s financial instability hypothesis (FIH) protracted prosperity leads endogenously to firms overleveraging themselves and transforming a market dominated by hedge finance into one dominated by speculative and Ponzi finance. Since Ponzi finance units are forced to sell off assets to service their existing interest payments, once the market is sufficiently dominated by Ponzi finance units, this creates an oversupply of assets offered for sale, and the resulting debt deflation causes a financial crisis and drastic shortage of liquidity. It appears this crisis state can be brought about by a deceptively low critical mass of Ponzi and speculative finance units. This paper uses a large 2002–2009 quarterly data set of all publicly traded North American firms and foreign firms traded on North American exchanges, a total of 8,905 stocks. Financial ratios are used to classify these firms in each quarter according to Minsky’s FIH categories. Market value is used to weight the categories, and average betas are computed as measures of volatility. Results provide dramatic support for the FIH. The FIH is then reinterpreted in terms of Austrian business cycle (ABC) theory, which depends on inflationary credit expansion to drive the unsustainable prosperity. According to Minsky’s FIH, unsustainable prosperity emerges endogenously as long periods of economic expansion make borrowers and lenders alike more willing to engage in investment activities for which they fail to see the inherent risk. It becomes clear that this process is amplified and exacerbated by credit expansion. Minsky’s FIH helps flesh out some of the missing dynamics of the malinvestment liquidation phase of ABC theory, and the two views turn out to be surprisingly complementary.