Systemic Fragility

Hedging, speculating and Ponzi financing are some key concepts that we are hearing a lot in this modern time and according to Minsky, these are the foundation to systemic fragility.

A unit is hedged if expected cash-flow from operations substantially exceeds its debt servicing commitments. It is engaged in speculative finance if it has to depend on periodically refinancing debts. A Ponzi unit has to constantly borrow more in order to meet its debt servicing commitments.

A prolonged period of stability would induce some units to migrate from hedge to speculative and others from speculative to Ponzi finance and this makes the system as a whole increasingly fragile. In a highly fragile economy, no identifiable exogenous shock is needed to unleash a crisis. Some trivial, random event would be sufficient to be the trigger.

What makes this analysis relevant in today’s content is that it describes a process of general leveraging as part of a business downturn. It is quite clear that it is a fallacy of composition to suppose that general leveraging can take place without a decline in asset prices and excess supply of goods and services in general. When leverage is increasing all around, with all parties buying on credit, all also find themselves making a profit. This reinforces the process.

The large investment banks had leverage ratios in the high 20s or low 30s. Hedge funds and some European banks may have been even more highly levered. When the sector as a whole attempts to de-leverage by reducing liabilities, a variety of de-stabilizing processes are set in motions.