aTheorisations of the global financial crisis of 2007-2008, widely regarded as the most calamitous since the Great Depression, have been varied and often divergent. The crisis’ scale and scope has given rise to its portrayal as a historical event in the evolution of world affairs (Altman, 2009; Bremmer, 2009; Woods, 2010), an effective rupture of Anglo-Saxon capitalism, and even as a crisis of a specific segment of the financial system, that is a crisis of securitisation (Nesvetailova and Palan, 2013; Soros, 2008; Wade, 2008; Wigan, 2010). This latter theoretical understanding – of the global financial crisis as driven by the fragility induced by financial innovation – will frame this paper.
As early as twenty years ago, then sparse literature on financial innovation identified a central stimulus of financial innovation as “a desire to circumvent existing regulations in taxation and accounting, without necessarily breaking the law” (Van Horne, 1985, cited in Shah, 1997). In what was becoming an increasingly deregulated market, the ability to creatively bypass regulatory restrictions through financial innovation provided competitive advantage to firms (McBarnet and Whelan, 1992; Shah, 1997, p. 86; Nesvetailova and Palan, 2013). In modern international political economy (IPE) analyses, financial innovation remains theoretically contested. Mainstream economics posits capitalism as thriving on innovation: the combination of the creation of new products and advances in technology promotes competition, efficiency, and growth, and is ultimately responsible for enhancing prosperity and welfare (Nesvetailova and Palan, 2013). Consequently, mainstream finance theory has consistently been centred around a paradigm of growth-promoting financial innovation, which has largely informed the regulatory framework of the global – and in particular the US – financial system.
For example, according to Nobel laureate in Economics Robert Merton, “innovations involving derivatives can improve efficiency by expanding opportunities for risk sharing, by lowering transaction costs and by reducing asymmetric information and agency costs” (Merton, 1995, p. 463). Moreover, financial innovation has widely been associated with the advancement of economic growth, the democratisation of access to credit, and the enhancement of societal welfare via the mobilisation of economic resources through financial markets. Specifically, financial innovation has been praised for its purported reliance on scientific approaches to managing economic and financial risk. According to one of its most vocal proponents, former Chairman of the US Federal Reserve (Fed) Alan Greenspan, financial innovation gave rise to the “new economy,” and was responsible for providing “net benefits for the majority of the American people,” as well as accelerating the US’ economic growth in recent decades (Greenspan, 2000, cited in Leathers and Raines, 2004). Greenspan also foresaw further increase in the pace of innovation, with virtually limitless types of new products and services that would be offered by financial institutions (Nesvetailova and Palan, 2013; Greenspan, 2000, cited in Leathers and Raines, 2004). Merton’s views coincided with Greenspan’s: “The rapid five-year growth in over-the-counter (OTC) derivatives reflects a growing confidence in the issuing institutions’ modeling and evaluation skills” (Merton, 1995, p. 463). Concerning potential risks posed by instruments of financial innovation – particularly derivatives – Merton’s colleague Myron Scholes, who was awarded the Nobel Memorial Prize in Economic Sciences for a method to determine the value of derivatives, concluded that “there is no empirical evidence that supports the conjectures that derivative contracts can lead to massive failures and create systemic risk” (Scholes, 1996, p. 285).
The ruinous combination of the major financial crises of the late 1990s – such as the dotcom bubble – and the global financial crisis of 2007-2008, has recently – albeit perhaps too late – motivated an emergent wave of critical perspectives on the role of financial innovation vis-à-vis economic stability (Bello et al., 2000; Bezemer, 2001; Kregel, 2001; Nesvetailova, 2006, 2007; Soederberg, 2004; Wolfson, 2000). This contrasts the previous era of the finance-led “new economy” characterised by the highly technical mathematical foundations of modern finance and the vehement encouragement of utmost financial liberalisation. In such an era, in the run-up to the crisis, doubts surrounding the ultimately beneficial nature of financial innovation and instruments stemming therefrom were theoretically and empirically difficult to uphold.
And yet Hyman Minsky did uphold such doubts. Having dedicated the majority of his work to the study of capitalist economies’ proclivity to experiencing financially-driven instability and booms and busts, Minsky did not live to witness the global financial crisis of 2007-2008, a crisis whose mechanics he had presciently described in almost lurid detail decades before its occurrence: “At present real estate assets seem to be a more important source of financial distress than stock exchange assets … real estate assets are collateral for an extensive amount of debt, both of households and of business firms, owned by financial institutions … If the price of real estate should fall very sharply, not only will the net worth of households and business firms be affected, but also defaults, repossessions, and losses by financial intermediaries would occur” (Minsky, 1964, p. 180-81). The labeling of the crisis as a “Minsky Moment” or a “Minsky Crisis” (Chancellor, 2007; Cassidy, 2008; McCulley, 2007; Whalen, 2007) and the use of Minsky’s theoretical framework of hedge, speculative and Ponzi stages of finance, have effectively catapulted Minsky into the limelight of public debate regarding the crisis. Brought forth from the “relative obscurity of heterodox political economy” (Nesvetailova and Palan, 2013), Minsky’s work has attracted unprecedented interest since the crisis’ inception, with many viewing the subprime crisis and its contamination of the rest of the global financial system as an empirical confirmation of the FIH.
The bulk of Minsky’s work was produced throughout the 1970s and 1980s, a period which saw mainstream economics gravitate towards increasingly sophisticated and technical methodologies. Contrastingly, Minsky’s FIH was concerned with capitalist financial systems’ inbuilt proclivity to financial instability and, specifically, with finance’s “natural instability” and subsequent ever-present risk of the recurrence of a major financial crisis (Palley, 2010; Nesvetailova and Palan, 2013). In Minsky’s own words, the FIH proffers “a theory of how a capitalist economy endogenously generates a financial structure which is susceptible to financial crises, and how the normal functioning of financial markets in the resulting boom economy will trigger a financial crisis” (Minsky, 1986, pp. 67-68). Minsky’s most famous aphorism elegantly sums up the crux of the Minskyan theoretical framework: “Stability – or tranquility – in a world with a cyclical past and capitalist financial institutions is destabilising” (Minsky, 1982, pp. 101). His belief in the profoundly destabilising effects of a tranquil economic and financial environment has been widely deliberated and adopted by commentators of the 2007-2008 crisis, including by adherents to the neoclassical orthodoxy from which Minsky’s scholarship had traditionally been so isolated.
His theoretical framework is appropriately described by US-based economist Thomas Palley as one of evolutionary instability resting upon two different cyclical processes: the basic Minsky cycle and the super-Minsky cycle (Palley, 2010). The basic Minsky cycle depicts the evolution of financing arrangements. In doing so, it charts the phenomenon of emerging financial fragility in business and households balance sheets (Palley, 2010). Within this cycle, consumers, firms and banks can be in a hedge, speculative or Ponzi position (Silipo, 2011). The first stage of the cycle, hedge finance, sees cash receipts exceed payment commitments from contracts (Silipo, 2011). Put simply, the borrowers or agents’ expected revenues exceed repayments of interest and loan principal. The cycle then shifts to a speculative stage, during which agents’ revenues can only cover interest repayments. Consequently, a speculative unit must issue new debt in order to meet commitments on maturing debt (Silipo, 2011). The final stage of the basic Minsky cycle is Ponzi finance, and it is reached when borrowers’ revenues are insufficient to cover interest repayments, leading to borrowers’ reliance on capital gains in order to meet their obligations (Palley, 2010). More specifically, when a speculative unit is forced to borrow or sell assets in order to meet interest repayments on its debts, it has engaged in Ponzi finance, thereby significantly undermining the security of its debt holders (Silipo, 2011; Minsky, 1992). The amalgam of hedge, speculative and Ponzi positions ultimately determines the stability of the overarching economy.
The business cycle as envisioned by Minsky through the lens of his FIH is underpinned by a behavioural and psychological assessment of financial units and agents. As the good times roll, optimism envelops agents (borrowers and lenders alike) and the market as a whole, leading to increasingly optimistic valuations of assets and associated revenue streams. In turn, this leads to increasingly enthusiastic financial risk-taking. The process of rising optimism was particularly evident in the development of the US housing bubble and the run-up to its subsequent bursting. Fervent belief in the aforementioned “new economy” and the “Great Moderation” hypothesis claiming that central banks’ radically improved monetary policy had successfully tamed the ebb and flow of the business cycle, manifested by Economics Nobel prize laureates and even former Fed Chairman Ben Bernanke, have been identified by Palley as evidence of the basic Minsky cycle at work (Palley, 2010).
Also according to Palley, while the basic Minsky cycle is inherent in every business cycle, the super-Minsky cycle is a long-phase cycle, unfolding over a period of several consecutive business cycles (Palley, 2010). Functionally, the super cycle erodes and transforms what Minsky has called “thwarting institutions” (Ferri and Minsky, 1992), or structures critical to ensuring the stability of capitalist financial systems, such as “business institutions, decision-making conventions, and structures of market governance, including regulation” (Palley, 2010). While both cycles operate concurrently, Palley argues that a major financial crisis only occurs when the super-Minsky cycle has sufficiently eroded the economy’s thwarting institutions. Essentially, the super cycle is responsible for allowing increasingly more financial risk into the economy through regulatory relaxation and more voracious risk-taking. Finally, he identifies an important dimension of this to be the role played by financial innovation in increasing the supply of risk throughout a financial system: new financial products and practices often escape the regulatory net by virtue of their novel and highly technical nature (Palley, 2010).
To summarise the FIH: Minsky’s basic thesis is that during periods of solid economic growth, when debts are easily covered by current cash flow, financial units are more likely to increase risky assets in their portfolios. The good times therefore make units more reliant on cash flow, more confident that smaller margins of safety are needed for success, and more likely to underestimate risk, ultimately leading to a diminution of the liquidity preference (Silipo, 2011). In Minsky’s own words, “Tranquillity … induces increases in capital asset prices relative to current output prices and a rise in (1) acceptable debts for any prospective income flow, (2) investment, and (3) profits. These concurrent increases lead to a transformation over time of an initially robust financial structure into a fragile structure” (Minsky, 1982, p. 111). The main source of such fragility relates to the means through which financial units raise capital; particularly important to Minsky is units’ reliance on debt as a source of cash flows (Nesvetailova and Palan, 2013). A boom period proffers banks and other financial institutions an ease of accommodating demand for debt through different means, including financial innovation. During the boom, new institutions and instruments are created; consequently, the quantity of money in a system becomes endogenously determined (Silipo, 2011).
In the context of the subprime crisis, securitisation is one such instrument that is particularly salient. On the matter of securitisation, Minsky penned a particularly prophetic work in 1987, stating “that which can be securitised will be securitised” (Minsky, 1987). According to this piece, “securitisation implies that there is no limit to banks’ initiative in creating credit, for there is no recourse to bank capital, and because the credits do not absorb high-powered money [bank reserves]” (Minsky, 1987, quoted in Silipo, 2011). Such insights reveal Minsky’s primary conviction that fragility within capitalist financial systems primarily stems from the process of financial innovation; such insights are particularly relevant in framing the discussion of the subprime crisis in Minskyan terms. Financial innovation’s essential function of providing financial intermediaries with the ability to “stretch the frontier of private liquidity” (Nesvetailova and Palan, 2013) in fact exacerbates systemic fragility, and ultimately magnifies the scope of the subsequent financial and economic collapse. In Minsky’s view, the proliferation of debt-driven financial instruments impacts the system’s liquidity in two ways: firstly, it increases the velocity of credit; secondly, “every institutional innovation which results in both new ways to finance business and new substitutes for cash decreases the liquidity of the economy” (Nesvetailova and Palan, 2013; Minsky, 1982, p. 173). The crux of Minsky’s theoretical framework is well captured by Nesvetailova: “Minsky showed that the mechanism that spreads fragility and crisis throughout the system involves a complex chain of liquidity-stretching financial innovations that appear to enhance liquidity but in fact, by replacing high-quality and more reliable assets, such as state-backed money, with privately created and riskier financial instruments, make the financial system progressively more illiquid” (Nesvetailova, 2007, quoted in Nesvetailova and Palan, 2013). In the run up to the 2007-2008 global financial crisis, a crowded landscape of shadow financial units – including SPVs, OTC derivatives, and other off-balance sheet operations – performing a primary liquidity-creating function, crystallised into an “underbelly” (Nesvetailova and Palan, 2013) of the traditional banking system. Such structures and instruments are key actors in the process of moving risk from the visible and regulated financial system squarely into the unregulated, or shadow, banking system (Nesvetailova and Palan, 2013). Returning to the specific case of securitisation: Levy Economics Institute economist Jan Kregel has identified structured securitisation’s ultimate purpose as its ability to produce what he has called “riskless arbitrage,” or its capacity “to convert less-liquid, higher-risk securities into securities that appear to be more liquid and lower risk” (Kregel, 2010, p. 11). In sum, financial innovation has been found conducive to changing risk profiles on both the asset and liabilities sides of the balance sheets of traditional banks and financial intermediaries alike. This, in turn, has given rise to secondary, parallel, or shadow banking systems (Nesvetailova and Palan, 2013).
In its 2014 Global Shadow Banking Monitoring Report, the Financial Stability Board (FSB) estimated the shadow banking system to accommodate an unprecedented $75.2 trillion (Financial Stability Board, 2014). Similarly, Goldin and Vogel, in assessing the explosive growth of the markets for sophisticated financial instruments and resale markets in capital, found that the OTC derivatives market had expanded to $600 trillion by the end of the so-called “Golden Decade” of finance, 1998-2007 (Goldin and Vogel, 2010, p. 2). Such staggering growth puts the value of the OTC derivatives market alone at sixteen times global equity market capitalisation and ten times the global GDP (Goldin and Vogel, 2010, p. 2). Consequently, what was originally conceptualised as a mere underbelly or outgrowth of the traditional banking system has in fact grown to such astronomical sizes as to exceed and engulf it, even as scholars observing the phenomenon have linked the emergence of such parallel banking systems with the occurrence of major financial crises. Mullineux, for example, argues that the UK secondary banking crisis of the early 1970s, with its roots in commercial property lending, makes for a good comparison to the 2007-2008 global financial crisis. According to him, the traditional banking system’s exposure to a parallel, or shadow, banking system plays a central part in both crises’ causation (Mullineux, 2010, p. 247). In this context, the visible (elements of the traditional banking system) and invisible (shadow financial units) nodes of financial relationships have become increasingly intertwined as a direct result of financial innovation (Nesvetailova and Palan, 2013). Goldin and Vogel’s aforementioned research found this phenomenon to have been aimed at buttressing systemic robustness, but to have instead ultimately “rendered the system fragile to targeted attacks on its hub nodes, with the potential for risk amplification and contagion” (Goldin and Vogel, 2010).
Kregel finds the “Golden Decade,” or latest – and arguably most significant – bout of financial innovation, best characterised by the practice of structured securitisation, to have created increased liquidity within the system. However, liquidity thus created is not subject to the same regulatory and prudential measures imposed on traditional financial units such as banks (Kregel, 2010, p. 11; Nesvetailova and Palan, 2013). Therefore, the 2007-2008 global financial crisis has correctly been posited as a crisis of illusory or artificial liquidity (Borio, 2000, 2004; Langley, 2010; Nesvetailova, 2010; Nesvetailova and Palan, 2013), or of the afore-described increasingly complex and technical web of financial intermediation. Furthermore, Minsky’s contentious link between financial innovation and systemic risk has rightfully gained much currency in the academic debate surrounding the crisis (Acharya and Richardson, 2009; Goldin and Vogel, 2010). The crisis did not revolve around a classical bank run scenario; instead, it was centred on a collapse of security values, insolvency within securitized structures, and a withdrawal of short-term funding (Nesvetailova and Palan, 2013), and was a ultimately a crisis of financial innovation.