Debt DOES matter

Hyman Minsky’s Financial Instability Hypothesis argues that a key mechanism that pushes an economy towards crisis is the accumulation of DEBT. There are three types of borrowers:

  1. Hedge borrower: borrows with the intent of making debt payments from cash flows from other instruments.
  2. Speculative borrower: borrows based on the belief that the appreciation of the value of the assets (e.g. Real Estate) will be sufficient to refinance or pay-off their debt, but who does not have sufficient resources to repay the original loan.
  3. Ponzi borrower: this type relies on continually rolling over the principal into new investments.

Minsky believed that Wall St. encouraged businesses and individuals to take on too much risk thereby generating boom-bust cycles and that the only way to break this pattern was governmental regulation. His theory states that there are 5 stages to a credit cycle: DISPLACEMENT, BOOM, EUPHORIA, PROFIT-TAKING, and PANIC.

  1. Displacement: occurs when investors get excited about something (e.g. the Internet, Wars, abrupt changes in Economic policies etc.). It would appear that the current cycle began in 2003, when Greenspan reduced short term interest rates to 1%, and an unexpected influx of foreign money (read: CHINESE) into US treasury bonds led to historically low borrowing costs (Mortgage rates).
  2. Boom: This event led to the subsequent speculative real estate boom, one that was far bigger than the previous bubble in technology stocks.
  3. Euphoria: banks and other commercial lenders extend credit to even more dubious borrowers, often creating new financial instruments to do that job (e.g. junk bonds in the 1980’s). In this latest incarnation it was the securitization of mortgages, which enabled banks to provide home loans without worrying if they would ever be repaid. Investors who bought these would have to deal with the defaults.
  4. Profit-Taking: By the middle of 2006 some savvy investors, realizing the combustible nature of the bubbling market, take profits.
  5. Panic: the onset of panic is often heralded by a dramatic event. In hindsight, that event would have to be the collapse of 2 Bear-Stearns hedge funds, which had invested heavily in mortgage securities, in 2007.

There is much blame to go around, many culprits, but (once again with the wisdom that only hindsight can provide) two stand out:

  1. Greenspan: lauded through the boom times as a genius, we now see that his stubborn belief in the ability of free markets to self regulate, his irresponsible act of keeping rates too low for too long, and his repeated ignoring of warnings, some from his own colleagues, about what was happening in the mortgage market, have to be seen as mitigating factors for the situation we find ourselves in currently. [to be fair, he wasn’t the only one who ignored the messages that the mortgage market was sending out]
  2. Government: The “successful” attempts by congress and the executive branch [from 1980 – 1999] to gradually weaken the regulatory bodies that supervise Wall St culminating with the abolition of the Glass-Steagall Act of 1933, which was meant to prevent a recurrence of the rampant speculation that preceded the great depression, by the Gramm-Leach-Bailey Act of 1999.

Noted economist, Irving Fisher in his Debt-Deflation theory, believes there are two major factors that lead to a depression as opposed to the garden variety recession, and those are Over-Indebtedness and Deflation. He outlines the steps leading to these outcomes:

  1. Debt liquidation leads to distress selling
  2. Contraction of deposit currency as bank loans are paid off, and a slowing down of velocity of circulation
  3. A fall in the level of prices – stronger dollar
  4. Greater fall in the NET worth of businesses, leading to bankruptcies
  5. Similar fall in profits
  6. Reduction in Output, trade, and Employment
  7. Pessimism and loss of confidence
  8. Hoarding and slowing down still more of the velocity of circulation
  9. Complicated disturbances in the rates of interest; a fall in the nominal rates and rise in the real rates of interest

Barring any counteracting force/event that occurs to prevent the fall in the price level, a depression similar to the one that happened from 1929-1933 (where the more debtors paid, the more they owed) is sure to happen. This will cause a crash of the financial system of the US and, by proxy, the world. To quote Fisher “ultimately, of course, but only after almost universal bankruptcy, the indebted-ness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This so-called “natural” way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation. On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.”


  1. Massive government spending needed to support the unemployed and prevent the implosion of state and local governments. Beyond this, spending will do nothing as it had nothing to do with the cause of the crisis and thus will have nothing to do with ending it. It is just a band-aid.
  2. Deflation must be halted and reversed and the credit system has to be restarted. Tremendously difficult propositions as these two concepts are tightly inter-related. Deflation will not stop if the collapse of the credit system is not contained BUT the collapse of the credit system will not stop UNTIL the deflation of asset and goods prices is controlled.
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