Minsky’s three-part taxonomy

Minsky distinguished between three types of finance—hedge finance,
speculative finance, and Ponzi finance—on the basis of the relation

between the operating income and the debt service payments of indi-

vidual borrowers. A firm is in the hedge finance group if its anticipated

operating income is more than sufficient to pay both the interest and

scheduled reduction in its indebtedness. A firm is in the speculative fi-

nance group if its anticipated operating income is sufficient so it can pay

the interest on its indebtedness; however the firm must use cash from

new loans to repay part or all of the amounts due on maturing loans. A

firm is in the Ponzi group if its anticipated operating income is not likely

to be sufficiently large to pay all of the interest on its indebtedness on

the scheduled due dates; to get the cash the firm must either increase its

indebtedness or sell some assets.

Minsky’s hypothesis is that when the economy slows, some of the

firms that had been involved in hedge finance are shunted to the group

involved in speculative finance and that some of the firms that had been

involved in the speculative finance group now find they are in the Ponzi

finance group.

The term ‘Ponzi finance’ memorializes Carlos Ponzi, who operated a

small loans company in one of the Boston suburbs in the early 1920s.

Ponzi promised his depositors that he would pay interest at the rate of

30 percent a month and his financial transactions went smoothly for

three months. In the fourth month however the inflow of cash from new

depositors was smaller than the interest payments promised to the older

borrowers and eventually Ponzi went to prison.

The term Ponzi finance is now a generic term for a nonsustainable

pattern of finance. The borrowers can only meet their commitments to

pay the high interest rates on their outstanding loans or deposits if they

obtain the cash from new loans or deposits. Since in many arrangements

the interest rates are very high, often 30 to 40 percent a year, the contin-

uation of the arrangement requires that there be a continuous injection

of new money and often at an accelerating rate. Initially many of the

existing depositors are so pleased with their high returns that they allow

their interest income to compound; the clich ́ is that they are ‘earning

interest on the interest.’ As a result the inflow of new money can be below

the promised interest rate for a few months. But to the extent that some

depositors take some of their interest returns in cash, the arrangement

can operate only as long as these withdrawals are smaller than the inflow

of new money.

The result of the continuation of the process is what Adam Smith and his

contemporaries called ‘overtrading.’ This term is less than precise and in-

cludes speculation about increases in the prices of assets or commodities,

an overestimate of prospective returns, or ‘excessive leverage.’3 Specula-

tion involves buying commodities for the capital gain from anticipated

increases in their prices rather than for their use. Similarly speculation

involves buying securities for resale rather than for investment income

attached to these commodities. The euphoria leads to an increase in the

optimism about the rate of economic growth and about the rate of in-

crease in corporate profits and affects firms engaged in production and

distribution. In the late 1990s Wall Street security analysts projected

that U.S. corporate profits would increase at the rate of 15 percent a

year for five years. (If their forecasts had been correct, then at the end

of the fifth year the share of U.S. corporate profits in U.S. GDP would

have been 40 percent higher than ever before.) Loan losses incurred by

the lenders decline and they respond and become more optimistic and

reduce the minimum down payments and the minimum margin require-

ments. Even though bank loans are increasing, the leverage—the ratio

of debt to capital or to equity—of many of their borrowers may decline

because the increase in the prices of the real estate or securities means

that the net worth of the borrowers may be increasing at a rapid rate.

A follow-the-leader process develops as firms and households see that

others are profiting from speculative purchases. ‘There is nothing as

disturbing to one’s well-being and judgment as to see a friend get rich.’4

Unless it is to see a nonfriend get rich. Similarly banks may increase their

loans to various groups of borrowers because they are reluctant to lose

market share to other lenders which are increasing their loans at a more

rapid rate. More and more firms and households that previously had

been aloof from these speculative ventures begin to participate in the

scramble for high rates of return. Making money never seemed easier.

Speculation for capital gains leads away from normal, rational behavior

to what has been described as a ‘mania’ or a ‘bubble.’

The word ‘mania’ emphasizes irrationality; ‘bubble’ foreshadows that

some values will eventually burst. Economists use the term bubble to

mean any deviation in the price of an asset or a security or a commod-

ity that cannot be explained in terms of the ‘fundamentals.’ Small price

variations based on fundamentals are called ‘noise.’ In this book, a bub-

ble is an upward price movement over an extended period of fifteen

to forty months that then implodes. Someone with ‘perfect foresight’

should have foreseen that the process was not sustainable and that an

implosion was inevitable.