Minsky on Uncertainty

In Stabilizing an Unstable Economy Hyman Minsky presents his financial instability hypothesis, which is that the nature of a capitalist system creates instability. Essentially, periods of sustained growth and tranquility (to use Joan Robinson's term) lead to the emergence of increasingly fragile and unstable financial / liability structures. When times are good, you want to invest for large expected future profits, accepting more and more debt to maximize success.

Since money is created through the process of borrowing and lending, this process has big effects on the economy. When perceived profit opportunities abound, entrepreneurs and bankers accept more and more debt financing as underwriting standards get lax, new forms of money are formed with financial innovations ... you've got high capital gains, more investment, more profit, things keep chugging along faster and faster ... phew! If it sounds too good to be true, it usually is. Through an investment boom the economy expands beyond its tranquil full-employment state, leading to accelerating inflation, financial and monetary crises, and debt deflations. This is all very reminiscent of Ray Dalio's summary of the economic machine.

Here I quote Minsky's summary on uncertainty, in the context of our world in which the decision to invest depends on investment supply (labor costs and short-term interest rates), investment demand (the price of capital assets), and the structure and conditions of internal (retained earnings) and external financing (bond or equity issues). Ultimately, the investment decision depends on the performance of the economy while the investment is "gestating".

"Thus, there is an element of uncertainty in the decision to invest that has nothing to do with whether the investment will perform as the technologists indicated and whether the market for the product of the investment will be strong. This element of uncertainty centers on the mix of internal and external financing that will be needed; and this mix depends upon the extent to which finance for the investment goods will be forthcoming from profit flows. 

"Since investment deals preeminently with decisions that involve time, in order to explain investment it is necessary to come to grips with the meaning and significance of uncertainty in economics. Uncertainty deals with that class of events for which the outcome of actions cannot be known with the same precision as the average outcome at a roulette table, or even of a mortality table, is known. In a word, uncertainty in economics does not deal with risks that are insurable or analogous to gambling risks. For example, the appropriate liability structure for holding any type of capital asset cannot be known in the same sense as the appropriate technology for manufacturing. Today's appropriate liability structure for holding any capital asset can be determined only on the basis of history and conventions. In the course of history there have been significant swings in the mix of internal and external financing of investment and much innovation in liability structures. Liability structures (and asset holdings by intermediaries) that were deemed safe when entered upon may turn out to be highly risky as history unfolds. 

"Uncertainty is largely a matter of dealing today with a future that by its very nature is highly conjectural."