From Phenomenal World, April 15:
We live in a period of unparalleled financial complexity, and, as the history of recent decades has demonstrated, unparalleled financial risk. The recurring crises which plague the global economy have brought theorists of systemic instability to the fore. Key among them has been Hyman Minsky, whose framework for understanding financial market fragility takes a cyclical form. In his model, an excessive credit expansion (“displacement”) fuels a speculative bubble (“mania”) and causes “financial distress,” leading to credit contraction and the bursting of the bubble (“panic”).
The appeal of Minsky’s model lies, in part, in its structural perspective. In contrast to the general tendency to disregard financial market practices, Minsky leveraged institutional and legal structures of the financial markets to develop his views. A classic example is his interpretation of the 1980s debt crisis—unlike orthodox theories of profit determination based on productivity and market power, Minsky linked firms’ performance to the developments of the financial market. Specifically, he focused on the 1980s merger and acquisition mania and the structure of junk bonds. Whereas neoclassical theories priced cash flows based on profitability, Minsky analyzed them as claims on firms’ tangible assets, which were often used as collateral for junk bond loans. In the 1980s, financial distress thus enabled issuers to refrain from making payments, generating a liquidity crisis that neoclassical frameworks could not understand.
In Minsky’s vision, instability is an essential characteristic of market structure. Because credit expansion depends on the creation of private monetary instruments, and a panic involves a flight from such speculative assets towards safe, liquid monetary liabilities issued by a central bank, his framework opens the way for analyzing how the hierarchy of monetary liabilities influences the stability of the system as a whole.
By demonstrating how instability is generated, Minsky’s theory is a valuable guide to policymaking aimed at controlling systemic risk. However, most of the work inspired by Minsky uses it to understand instability after the fact. In examining the ex-ante formation of systemic risk, economists narrowly focus on the status of short-term funding and monitor a few liquidity or volatility indicators. Consequently, the structural and institutional aspects of derivative markets, payment systems, and the supply chain of collateral, remain a black box. I take the black box as my primary point of departure—examining the intricate workings of financial stability through market microstructures underlying financial flows.
The most established financial flow indicator is the flow of funds. Inspired by Walter Bagehot’s monetary world and Minsky’s market structure vision, macroeconomists began to examine sources and uses of short-term funding. Traditionally, the flow of funds was sufficient to capture the market structure’s resilience and financial stability. This is because the financial participants’ search for liquidity represented the real economy’s aggregate demand. However, the flow of funds alone cannot sufficiently reflect the institutional realities of the modern financial ecosystem.
For example, in a shadow banking system, the demands for short-term funding are not driven by transaction needs in the real economy. Instead, they reflect the state of the collateral supply chain, institutional aspects of the derivatives market, and the structure of payment systems. Therefore, to analyze financial stability, we should update the measure of financial flow and supplement the flow of funds with three new sets of flows: the flow of collateral, the flow of risk, and the flow of payments....
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