12.3 Fraudulent behaviour and scandals in nancial markets

maintain sufcient net reserves to meet gross payments due or to permit renanc-

ing, which will only be possible if expected future revenue is thought sufcient. The

net revenue depends on investment and thus the ability to nance new investment

depends on the expectation that the new investment will generate sufcient cash ows

to repay or renance current debt. An economy with private debt is thus vulnerable

to changes in the pace of investment. Instability follows from the subjective nature

of expectations about the future level of investment and the returns from it, and

the subjective determination by banks and their business clients of the appropriate

liability structure for the nancing of positions in different types of capital assets.

Uncertainty is thus a major determinant of cycles.

Minsky starts with an economy with a memory of recession. In such an economy,

acceptable liability structures and contractual debt payments are based on margins

that reect the risk that the economy may not perform as well as expected. As the

period in which the economy performs well lengthens and the memory of recession

fades, margins for safety decline and investment increases. The period of steady

growth is transformed into a speculative boom. This process is reinforced by nancial

innovation, including the introduction of new nancial instruments, which appear

when economies are thriving. Speculative economic units expect to full their

obligations by raising new debt and are vulnerable on a number of fronts, particu-

larly to rises in nominal interest rates, which increase their cash repayments relative

to their expected future receipts. Not everyone engages in speculative nance. The

more risk-averse continue to operate with hedge nance, which takes place when

cash ows from operations are expected to be large enough to meet debt commit-

ments as they fall due. Speculative nance, on the other hand, anticipates the need

for renancing. In addition to hedge and speculative nance, Minsky refers to ‘Ponzi

nance’, by which he means super-speculative nance that requires payments on

debt to be met by further borrowing, thus increasing the total debt outstanding.

It is named after Charles Ponzi (1882–1949), an Italian immigrant to the US who

became one of the great American swindlers.

High and rising interest rates can convert hedge nance into speculative nance

and speculative nance into Ponzi nance. Ponzi nance cannot continue for long

because information from the revealed nancial weakness of some units affects the

willingness of banks and businessmen to debt nance others. The curtailment in

investment nance causes investment to fall, leading to a decline in protability and

the ability to sustain debt. Unless this decline in investment is offset by an increase

in government spending, a panic can develop quite suddenly as pressure builds to

reduce debt ratios. Thus, in Minsky’s theory, the normal functioning of the nancial

system in a recovery period leads to a boom and a nancial crisis.