The financial crash in 2008 came as a surprise to most economists. The believed markets were sufficient and will produce prosperity for all if left to their own devices. However one little known economist had predicted it and developed a theory explaining it. He devised a theory explaining how lenders become lax with their standards, over optimistic and over extend themselves leading to a crash. Even more impressively he did this back in the 70s and 80s so can’t be accused of jumping on the bandwagon. His name is Hyman Minsky (1919-1996) and the theory is called “The Financial Instability Hypothesis”.

Minsky divided the financial sector into three groups. Hedge borrowers (meant in the traditional term of hedging a bet, i.e. making a safe bet, as opposed to hedge funds) who can afford to pay back the loans they take out. Speculative borrowers who could only afford to pay the interest on the loans they owe and Ponzi borrowers who couldn’t even afford to pay the interest. It is when Ponzi borrowers dominate the financial market that crisis occurs. When the bubble pops they are the first to default and start a domino effect.

Minsky argued that economies follow a cycle of boom and bust. Recovery leads to boom leads to euphoria leads to crash leads to recession leads to recovery. The seeds of failure are laid in success and vice versa. Minsky makes it clear that a free market economy will inevitably have a financial crash. He argues that action taken will usually reinforce the cycle; in other words, people will naturally make the boom reach higher levels and the bust reach lower levels. A key part of Minsky’s ideas is that “success breeds failure”. The nature of the success makes people reckless, which leads to failure. Although it sounds counter-intuitive, stability is destabilizing.

In the recovery after a crash, investors and banks are conservative and avoid risk. Banks only lend and businesses only invest if they are guaranteed a return. Almost all investors are hedge investors. This cautious policy is successful and encourages further risk taking. This leads to a boom when there is a lot of investment and good returns. Investors switch from being hedge investors to being speculative ones. People become convinced that there are solid reasons for growth and that a lot of money can be made. This becomes a self-fulfilling prophecy and as everyone gets in on the act it leads to euphoria. This is where the markets go mad. Ponzi investors dominate this market. Everyone is convinced that even worthless goods are actually valuable and extraordinary risks are taken. Banks fuel this boom by reckless lending and investors take huge risks. Investors fund themselves by taking out massive loans they cannot pay back unless asset prices rise in value. Everyone is convinced they are in a new era of prosperity.

At a certain point, known as the “Minsky Moment”, everything comes crashing down. Anything, even the most minor of things could act as a spark to launch a domino collapse of the financial sector (think of the snowball effect). The ponzi investors are the first to go and they pull everything down with them. People run out of cash to pay the most reckless of loans. When the assets are confiscated and sold by the bank, prices start to drop. Everyone panics. This leads to massive drops in prices which destroys investors which in turn destroys banks who in turn call in their loans which pulls down the rest of the economy, leading to recession. After a period of falling income, high unemployment and low growth the economy eventually begins a recovery and the cycle begins again.

Minsky argued that government budget deficits were a stabilizing factor. Government debt was a risk free investment which stabilized banks balance sheets. On the other hand, if government sun a surplus then banks turn to more risky investments. There are actions that the government can take to prevent the collapse. It can run a large budget deficit to boost the economy, which will help businesses and increase profits. Likewise the central bank can intervene as a lender-of-last-resort or to reduce interest rates. This leads to inflation and low growth but it prevents a recession. While it avoids a recession it really only pushes it into the future, as the conditions soon become established for the cycle to repeat itself. By failing to learn from their mistakes, investors will continue to make them. Reckless lenders and ponzi investors will continue to operate. Investors may become even more reckless if they think the government will always bail them out. The risk of financial collapse is only postpones not avoided.

If on the other hand inflation is low when the Minsky Moment occurs and the government decides not to intervene, then investors do not have the cash to pay off their debts. They default which puts lenders under strain. When lenders try to recoup their money by selling assets, this drives prices down and bankrupts more investors, putting more strain on lenders and so on. The economy spirals downwards gaining momentum in a series of price drops and bankruptcies feeding on each other leading to a depression. This is known as debt-deflation.

A look at history shows the truth in what Minsky said. Ireland’s banks were conservative until the boom of the early 90’s. The memory of the 80’s prevented them from being too rash or optimistic. However the boom lead to an increase in investment, which after 2002 resembled the euphoria stage. There was a host of reckless gambles by ponzi investors. The Minsky Moment occurred in late 2008 and we are currently in the recession stage.

A look at American stock market history supports Minsky’s claim that it was a cycle. The market peaked in 1929 after much mania and euphoria before leading to a depression. Lending was tight until the boom of the 50’s and 60’s and the market reached 1929 levels (adjusted for inflation) in 1954 before peaking soon after in 1966. The market bottomed out before booming in the 80’ and crashing in 1987. The actions of the Fed on that occasion postponed a recession by building up a future one. The boom of the 90’s lead the crash in 2001. This recovered only to crash in 2008. History is full of the recurring picture of good times leading to lax standards leading to financial crash.

Hyman Minsky died in 1996 as a little known economist. However since the 2008 crash there has been an upsurge in interest in his ideas. His prediction and theory of financial rash has lead to the declaration that we are all Minskyians now. Most economists were caught unaware and at a loss to explain how the free market naturally crashed. One man could.